An Analysis and Proposal for Insider Trading Regulation

Transcription

University of Pennsylvania Law School
Penn Law: Legal Scholarship Repository
Faculty Scholarship
1991
Start Making Sense: An Analysis and Proposal for
Insider Trading Regulation
Jill E. Fisch
University of Pennsylvania Law School, [email protected]
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START MAKING SENSE: AN ANALYSIS
AND PROPOSAL FOR INSIDER TRADING
REGULATION*
Jill E. Fisch**
When C harles Dickens wrote " the law is a[n] ass ,"1 he might
well have been describing the law governing insider trading.2 The
history of government enforcement in this area, including the re
cent litigation over broker Robert Chestman 's trading in
Waldbaum stock,3 demonstrates that the legal restrictions on trad
ing securities while in p ossession of material non public information
are confused and confusing. 4 The legal uncertainty has been attrib-
* Copyright b y J ill E. F i s c h , 1 99 1 . T h e title refers t o the TALKING HEADS film SToP
MAKING SENSE ( Columbia Pictures 1 984) and the album of the same name.
* * Associate Professor, Fordham U n iversity School of Law; B.A. 1982, Cornell U niversity;
J . D . 1 985, Yale Law School. I a m grateful to Victor Brudney, Roberta Karmel, Donald
Langevoort, Roberta Romano, and Steve The! for reading and commenting on earlier drafts
of this Article and to Gary Leibowitz for his research assistance.
' CHARLES DICKENS, OLIVER TWIST 335 ( Oxford Univ. P ress 1 966) ( 1 838) .
2 The term i ns ider trading is generally used to describe trading in securities on the basis
of material nonpublic information about the securities themselves, the issuer of the securi
ties, or the market for the securities. In its broadest sense, insider trading can be conducted
by those who are not typically considered corporate insiders and may include trading that
does not violate existing law as well as conduct that has been held to be unlawfu l . Cf. DoN·
ALD C. LANGEVOORT, I NSIDER TRADING REGULATION 5 ( 1 991 ) (definin g insider trading as "un·
lawful trading i n securities by p e rsons who possess material nonpublic i n formation about
the company whose shares are traded or the market for its shares").
3 See United States v. C hestman, 903 F.2d 7 5 (2d Cir. 1 990), vaca ted in part on reh 'g ,
947 F.2d 551 (2d Cir. 1 9 9 1 ) ( en bane) . After the Second Circuit overturned his criminal
conviction, Chestman attempted to modify his civil settlement with the Securities and Ex
change Commission (SEC) on the basis that the decision i n the criminal case cast doubt on
the legal basis for the civil action. The court refused to overturn the settlement agreement.
SEC v. C hestman, 87 C iv. 7 1 48 (RJW) ( S . D . N.Y. 1 99 1 ) ; see Court Rejec ts Efforts by Ex·
St ockbroker to Block Paymen t from Sett lement Fun d , 23 Sec. Reg. & L . Rep. (BNA) No.
10, at 369 ( Mar. 8, 1 99 1 ) .
' See, e.g . , SEC- CFTC Compromise to Receive Priority When Congress Convenes i n '91,
Dobb Says, 22 Sec. Reg. & L. Rep. (BNA) No. 45, at 1 59 1 -98 ( Nov. 1 6 , 1 990) ( reporting
suggestion by panelists at Nov. 9, 1990 Annual Meeting of ABA Business Law Section on
Federal Regulation of Securities Commission that Chestman decision could revive interest
in a legislative definition of insider trading) .
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uted to the absence of a statute defining the prohibited conduct.5
Because the government has devoted increased time and resources
to the battle against insider trading and has taken an aggressive
l itigation posture whereby it seeks to draw an ever-greater scope of
activity into the web of prohibited conduct,6 the ambiguity of the
regulations is particularly troubling.
• Many commentators have publicly expressed concern over the absence of clear statutory
guidelines. See, e.g. , James D. Cox, Choices: Paving the Road Toward a "Defin i t i o n" of
Insider Trading, 39 ALA. L. REv. 3 8 1 , 381 ( 1 988) ( " [Ijt is i m perative that Congress define
insider trading."); Donald C. Langevoort, S e t t i ng the Agenda f o r Legislative Reform: S o m e
Fallacies, Anomalies, a n d Other Curiosities i n t h e Prevailing L a w o f Insider Trading, 39
ALA. L. REv. 399, 409 - 1 3 (1 988) (calling for r e form of insider trading regulatio n ) ; Richard M .
P h i ll i ps & Larry R. Lavoie, The SEC's Proposed Insider Trading L egis la t ion: Insider Trad- .
ing Controls, Corpora te Secrecy, a n d Full Disclosure, 39 ALA. L. R E v 439, 440 ( 1988)
( " [T]he case-by-case approach has failed to produce a rational, comprehensible definition
that the average person can apply with predictability."); Richard M . P hillips & Robert ,J.
Zutz, The Insider Trading Doctrine: A Need for Legislative Repair, 1 3 HoFSTRA L. REv. 65,
7 1 ( 1984) (citing need for legislation to "strip insider trading restrictions from the rubric of
fraud") ; Iman Anabtawi, Note, Toward a Definition of Insider Trading, 41 STAN. L. REv.
377, 385 ( 1989) (arguing existing prohibition i s inconsistent and fails to consider i mpact on
market efficiency of i nsider trad i n g ) ; see a lso Elkan A bramowitz, Defin e or A bs ta i n: The
Congressiona l Gap in Insider Trading, 204 N.Y L.J. 3, 3 ( 1 990) ( " [l ] ndividuals are subject
to severe criminal sanctions for a crime that has never been defined or expressly p rohibited
by federal statute . . . . " ) ; Roberta S . Karmel, Defining Insider Trading, 198 N.Y L.J. 1, 34
( 1 987) (stating that fai lure to define conduct which is subject of criminal sanctions violates
due p rocess) ; Otto G. Obermaier, Who 's an Insider? Wha t 's Inside<, 196 N.Y L.J. 1, 2 ( 1986)
(stating that "convoluted legal theorizing" about insider trading is necessary because of a b
sence of statutory definition ) ; H arvy L . P itt & K a r l A . Groskaufmanis, Family Ties, Tip
pees a n d the Chestman Decision: Time for a Principled Definition of Insider Trading, IN
SIGHTS, July 1 990, at 7 ( c iting "pressing need" for statutory definition of insider trading);
Moncito Williams, What 's Lega l-a n d What's Not , FoRTUNE, Dec. 22, 1 986, at 36 ( noting
that i nsider trading rules are " amazingly vague"); SEC u. ?, WALL ST. J, Nov. 20, 1 986, at 34
( bl aming SEC for lack of clear d e fi n ition for insider trading) .
When Congress promulgated the Insider Trading Sanctions Act of 1 984 it considered i n
cluding a definition of insider trading b u t decided not t o do s o , believing that t h e existing
substantive law was adequately clear. Insider Trading Sanctions Act of 1983: Hearings o n
H.R. 559 Before the Subcomm. o n Securities o f the Sen a t e Comm. o n Banking, Housing
and Urban Affairs, 98th Cong., 2d Sess. 33-39 ( 1984 ) ; Definition of Insider Trading (Part
!): Hearings Before the Subcomm. o n Securities of the Sen a t e Comm. on Ba nking, Housing
a n d Urban Affa irs, 1 00th Cong. , 1 st Sess. 3 ( 1987) (statement of Sen. D'Amato) ( calling it
" absolutely unrealistic to go by the standard which says, 'Well, I know it when I see it but I
can't tell you what it is. I can't define it.' " ) ; cj. 1 3 3 Co N G. REc. S8246 (daily e d . June 1 7 ,
1987) (statement o f Sen. Riegle) ( " [ U]ncertainties in t h e law a r e bad for both the govern
ment and law abiding market participants . . . . [U ] n certainty about what conduct is or is not
i l l egal creates confusion, causes needless anxiety for persons who desire to obey the law . . .
and promotes d isrespect for the law. " ) .
6 See
infra notes 90- 1 1 3 a n d accompanying text for examples of t h i s expanded
prohi bition.
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INSIDER TRADING
1 99 1 ]
181
The lack o f clear guidelines can b e attributed, at least i n part, to
the legislative policy of keeping the scope of prohibited conduct as
broad as possible.' The consequence, however, is that traders are
receiving prison sentences8 for conduct that, at the time of prose
cution, presents j udicial issues of first impression.9 The imposition
of prison terms in such cases implicates obvious due process
con cerns.1 0
7 By defining insider trading, some legislators fear they will be creating a " roadmap for
fraud" by providing guidance to traders as to activities that do not fall within the statutory
prohibition. See, e.g. , Stuart J . K aswell, An Insider's View of the Insider Trading and Se
curities Fraud Enforcement Act of 1988, 45 Bus. LAw. 1 45 , 1 50 ( 1 989) ( detailing opposition
of Chairman Dingell of Subcommittee on Oversight and I nvestigations of H ouse Committee
on Energy and Commerce to enacting statutory definition) . Although the government's con
cern that a definition will constrain enforcement attempts is valid, the alternative is expan
sion of the criminal law through a form of judicial legislation, a process that is contrary to
traditional con...ti tutional and historical limitations on the development of criminal law. See
John C . Coffee, Jr., The 'Tip ' of the Bunny 's Nose: Sniffing Out Crime Where None Exists,
LEGAL TIMES, Sept. 25, 1 989, at 34, 35 ( noting that law of insider trading is developing
through after-the-fact judicial decision making and that this practice violates separation-of
powers doctrine).
The SEC has continually opposed the enactment of a statutory defi n ition. S e e HR REP.
No. 355, 98th Cong., 1 s t Sess. 1 4, reprinted in 1 984 U . S . C . C.A.N. 2274, 2 287 ( relying on
SEC recommendation that "any effort to define insider trading would result in . . . a rule
that leaves gaping holes" ) . The General Accounting Office, however , recommended that
Congress enact a statutory definition. UNITED STATES GENERAL AccouNTING O F FICE. REPORT
TO THE C H AIRMAN, SuscoMM. ON OvERSIGHT AND INVESTIGATIONS C oMM. oN ENERGY AND CoM
MERCE. HOUSE O F REPRESENTATIVES: SECU RITIES REGULATION, EFFORTS TO DETECT, INVESTI
GATE. AND DETER INSIDER TRADING 3, 6 1 -63 ( 1988 ) .
8 Robert Chestman was sentenced to t w o years in j a i l , s o m e of which had b e e n served by
the time his conviction for insider trading was reversed by the Second Circuit panel. United
States v. Chestma n , 903 F.2d 7 5 (2d Cir. 1990 ) , vacated in part on reh 'g, 947 F . 2d 551 (2d
Cir. 1 99 1 ) (en bane ) ; Martin Flumenbaum & B rad S. Karp, Second Circuit Review, 203 NY
L.J. 3 , 5 ( 1990 ) . R . Foster Winans was sentenced to an 1 8 - m onth term i n prison. Un ited
States v. Carpenter, 791 F.2d 1 024 (2d Cir. 1 986) , aff'd by a n equally divided Court, 484
U.S. 1 9 , 24 ( 1987 ) ; M artin Kimel, Note, The Inadequacy of Rule JOb-5 to A d dress Ou tsider
Trading by Reporters, 38 STAN. L. R Ev 1 549, 1 54 9 n . 1 ( 1 986). Even in the 1 970s, before the
emphasis on prison sentences for insider trading, Vincent Chiarella, a financial printer, \Vas
sentenced to serve one month in prison. U nited States v. Chiarella, 588 F.2d 1 358, 1364 n.7
( 2d Cir. 1978), rev 'd, 445 U . S . 2 2 2 ( 1 980) .
9 See Kaswell, supra note 7, at 1 5 1 ( describing Congressman Rinaldo's position in favor
of enacting a definition) . According to Kaswell, Congressman Rinaldo believed it was " un
reasonable for the securities industry and the public to be subject to severe penalties for a
crime that some say can be und erstood only after a detailed textual exegesis of cour t deci
sions and administrative proceedings. " Id.
10
The Ches t m a n case demonstrates the difficulties associated with the "fl exible" concept
of insider tr::�ding espoused by the SEC. C hestman argued to the Second C ircuit that a
criminal prosecution under the existing insider trading regulation violated his due process
rights. See, e.g . Reply Brief for A ppellant at 24; United States v. C hestman, 90:3 F.2d 75 (2d
.
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GEORGIA LA W RE VIE W
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The absence o f a clear definition o f the prohibited conduct may
also hamper the efficient functioning of the capital markets. In an
efficient market, all available information about a corporation and
its securities will be incorporated into the stock price.u If, how
ever, analysts and traders must investigate fully the source of all
trading information in order to protect themselves from prosecu
tion, they will be unable to trade rapidly on rumors, hearsay, and
other common sources of information. 1 2 Similarly, if all market
p articipants are subject to a duty to disclose or abstain based sim
p ly on their possession of m aterial nonpublic information , they will
be discouraged from attempting to seek out superior information
because of their inability to profit from it. 1 3 The Supreme C ourt
Cir. 1 990) ( No. 89- 1 276) ("It is thus fundamentally unfair to punish as a felon a stockbroker
who could not possibly have been expected to understand and conform to esoteric theories
construing undefi ned laws under ambiguous circumstances. " ) (on file with the Georgia Law
Review).
When Judge Jon 0. Newman inquired at the e n bane reargument of the C h es t man deci
sion why the SEC had not promulgated a definition of insider trading, Paul Gonson, arguing
on behalf of the SEC, responded that the SEC h a d been unable to do so because de.fi ning
insider trading was "too daunting a tas k . " K ar l Groskaufmanis, The SEC's Enforcement
Nose Dive, LEGA L TIMES, Dec. 1 6, 1 9 9 1 , at 2 1 . The obvious response to this argument, as
observed by the court, is that i f the S EC cannot define insider trading, how can C h estman
be expected to?
At least one commentator has also argued that this form of jud icial legislation v iolates
constitutional principles of separation o f powers. C offee , supra note 7, at 3 5 .
" S e e , e.g. , B asic, Inc. v. Levinson, 4 8 5 U.S. 2 2 4 , 24
6 ( 1988) (" Recent e m p irical studies
have tended to confirm Congress' premise that the market price of shares traded on wel l
developed markets reflects all publicly available i n formation . . . . " ) . T h e e fficient market
theory, or efficient capital market hypothesis, has achieved wide acceptance by the legal
culture. !d. at 253 n.4 (White, J., d issenting i n part) ( quoting Ronald J . G i lson & Reinier H.
Kraakman, The Mechanisms of Mark e t Efficiency, 70 VA. L REv. 549, 549-50 ( 19 84 ) ) . For a
detailed d iscussion of efficient market theory and an analysis of whether the stock markets
function e fficiently, see Lynn A. Stout, The Unimportance of Being Efficient: A n Economic
A n a lysis of Stock Market Pricing a n d Securi ties Regu l a tion, 87 MICH. L. REv. 6 1 3 ( 1 988 ) .
S e e also D aniel R . Fischel, Use of Modern Finance Theory i n Securities Frau d Cases In
vo lving Actively Traded Securities, 38 Bus. LAw. 1, 4 n.9 ( 1 982) ( citing efficient m arket
theory literature).
12
M any traders, notably risk arbitrageurs, make their profit by trad ing on information
that is not wholly public, at least in the sense that such information is not yet fully reflected
in stock prices. See Coffee, supra note 7 , at 34.
13 As Professor Brudney observes, " [e ] xploration for relevant corporate and economic i n
formation is a service o f value i n t h e functioning of t h e market." Victor B ru d n ey, Insiders ,
Outsiders, and Informa tional Advantages Under the Federal Securities Laws, 93 H A RV. L.
REv. 322, 3 4 1 ( 1 979) . This exploration is costly, however, and will not be undertaken unless
the discoverer of the i n formation has the opportunity to capitalize on his d i scovery. The
most direct way for the discoverer to capitalize on the informational advantage is by buying
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INSIDER TRADING
has expressly recognized that securities analysts perform an essen
tial function in making the markets more efficient by disseminat
ing market information and causing that information to be re
flected in stock prices.14 This role cannot survive in a market in
which trading is permitted only upon a parity of information. 15
The litigation history of insider trading reveals fundamental dis
agreement over the rationale behind the prohibition as well as its
s cope. The prohibition has been developed within the framework
of federal securities fraud , and the resulting case law contains logi
cal as well as interpretive flaws. Moreover, litigation under the the
ories of liability developed by the courts illustrates the practical
drawbacks to a judge-made crime. The existing doctrines fai l to
give adequate notice of prohibited conduct and present issues of
interpretation that are simply unacceptable in a criminal statute.
Concern that prohibited conduct be properly delineated has in
tensified with congressional authorization of increased penalties for
insider trading, the devotion of greater resources to criminal in
sider trading prosecutions, and the government's announced inten
tion to seek prison sentences more frequently.16 This enforcement
activity poses a grave threat to due process concerns in the absence
or selling securities. !d.
" D irks v. SEC, 463 U.S. 646, 658 (1983).
" Thus, in Dirks, the Court noted, " I m posi n g a duty to d isclose or abstain solely because
a person knowingly receives material , nonpublic i n formation from an insider and trades on
it could have an inhi b i ting influence on the role of market analysts, which the SEC itself
recognizes is necessary to the preservation of a heal t hy m arket." !d. at 658.
16
See The Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L . No.
1 00-704, 1 02 Stat. 4677 ( codified as amended a t 15 U . S . C . A. § 78 (West 1981 & Supp. 1991))
(" ITSFEA") ( increasing statutory penalties and remedies for insider trading); The Insider
Trading Sanctions Act of 1984, Pub. L . No. 98-376, 98 Stat. 1264 (codified as amended at 15
U.S.C.A. § 78 ( West 1981 & Supp. 1991)); Howard M . Friedman, The Insider Trading and
Securities Fra u d Enforcement A c t of 1988, 68 N.C. L. REv. 465, 476-81 (1990) ( ex plaining
how ITSFEA clarified and expanded penalties for insider trading). The House Committee
that drafted the 1988 amendments to the Securi ties Exchange Act of 1 934, § l, 15 U S.C §
78 (1988), expressed a desire to see a greater i m position of p rison senten ces in insider trad
ing prosecutions.
The Committee's interest i n the rr.aximum jail term i s a n explicit congressional
statement of the heightened seriousness with which insider trading and other
securities fraud offenses should be viewed. Alth ough the legislation does not
include an explicit mandatory minimum sentence the Committee believes in
the strongest possi ble manner that courts should i mpose jail terms for the
com m ission of these crimes, and expects that raisi ng the ceiling will i ncrease
the certainty of substantial prison sentences.
HR HEr. i·-Jo. 910, 100th C ong., 2d Sess. 23, reprinted in 1988 U.S.C.C.A.N. 6 0 4 3 6060.
,
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of clear standards for traders as t o the legality of their conduct.
Finally, because the United States was one of the first countries to
develop extensive insider trading regulations and enforcement
mechanisms , its experience has served as a model for much re
cently enacted regulation by foreign sovereigns 1 7 and is receiving
increased attention from the E uropean Economic Community
( EE C) in connection with its harmonization of European securities
regulations. 1 8
This Article will demonstrate that the doctrine under which in
sider trading is regulated is seriously flawed. Many of the flaws can
be attributed to the fact that insider trading regulation has been
developed on an ad hoc basis, with insufficient thought given to its
rationale. The Article will review this development and examine, in
particular , the judicial determination that insider trading is decep
tive and thereby fraudulent because of the insider's breach of a
fiduciary duty. After identifying the problems with this approach,
the Article will turn to the question of whether i nsider trading
should be illegal and, if so, why. C oncluding that regulation can be
j ustified by both political and market forces, the Article will pro
pose a revised regulatory scheme that clarifies the application of
the prohibition while removing the twisted logical basis upon
which the existing regulation is founded.
I.
OvERVIEW OF INSIDER TRADING
Many of the difficulties with existing insider trading law result
from its uneasy legal source. The federal securities laws do not
" See LANGEVOORT, supra note 2, at 483-521 ( describing development a n d status ot in
sider trading regulation i n various foreign j urisdiction s ) . insider trading (or insider dealing,
as it is commonly referred to abroad) is also receiving increased attention overseas due to
the proliferation of recent insider trading scandals outside the U n i ted States. Notable
a mong these were the Tateho C hemical I ndustries Co. scandai and the Recruit Cosmos Co.
scanda l in Japan and the Pechiney affair in France. For a description of the Tateho Chemi
cal scandal, see Tomoko Akashi, Note, Regu l a t ion of Insider Trading in Japan, 89 CoLLr�o.t
L. REv. 1296, 1302-03 (1989). For a description of the Recrui t Cosmos scanda l , see David
W i l l iams, A Primer for Japan's L a t es t Political Scandal, LA TIMES, Apr. 16, 1989, pt. 5, at
2. For details on the Pechiney affair, see H . R. REP. No. 240, 101st Cong. , lst Sess. 6-7 (1989);
LANCEVOORT, supra note 2, at 499-500.
'" The European Economic Community has recently adopted an Insider Deal ing Direc
tive, which sets forth m i n i mum regulatory standards for member states. The final version of
the Ins ider Dealing D irective is printed at 1989 O.J. (L 334) 30. A detailed analyo:.is of the
Insider Dealing D i rective can be found in K laus J. Hopt, Th e Europea n Insider Dealing
Dlrectice, '27 co�.!M. MKT. L. REV. 5 1 (1990).
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INSIDER TRADING
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contain an express prohibition of insider trading . 1 9 Instead, the
co nclusion that insider trading is i llegal has evolved from SEC and
judicial interpretation of the general antifraud provisions of the
federal securities laws , section 1 0 (b) of the Securities Exchange
A ct20 (the Exchange Act) and SEC Rule 1 0b-5 thereunder.2 1
19 The only sections of the Securities Exchange Act of 1 934 that directly address trading
by insiders are section 1 6, 1 5 U . S . C . § 78p ( 1988) (sometimes referred to as the "other i n
sider trading statute," see, e.g. , DoNALD C . LANGEVOORT, INSIDER TRADING REGULATION c h . 1 0
( 1 9 9 1 ) ( d escribing section 1 6 a s a " secondary tool" i n fight against insider trading)) and
section 20A, 1 5 U.S.C. § 78t- 1 ( 1 988) ( added by the 1 988 amendments to the Exchange Act) .
Broadly speaking, section 1 6 ( b ) provides that profits earned by statutory insiders-defined
as officers, d irectors, and 10% stockholders-through short-term trading in their company's
stock belong to the corporation. Section 1 6 ( a ) requires the reporting of all i nsider trades to
the SEC on a monthly basis, and section 1 6 ( c ) prohibits certain insider trading outright,
including short sales and selling against the box. Section 16(b) describ es as its purpose the
prevention of "the unfair use of i nformation which may have been obtained by [an insider]
by reason of his relationship to the issuer." Liability under section 1 6 does not require the
misuse of inside i n formation; the provision i mposes strict liability on the basis of short-term
trading. 1 5 U.S.C. § 78p ( 1 988) . Nor does its coverage extend to trad ing on the basis of
i nside information, if that trading does not take place within the statutory six-month pe
riod. !d. Because of these l imitations, commentators frequently have described section 1 6 as
a "blunt tool" for the regulation of i nsider trading and have expressed d issatisfaction with
it. See, e.g. , Steve The!, The Genius of Section 16: Regu l a ting the Managem e n t of Publicly
Held Companies, 42 HASTINGS L.J. 391 , 396 n n . 9 & 1 0 ( 1 99 1) (citing descriptions of section
16 as "crude" and "arbitrary"). When the Exchange Act was passed, however, Congress felt
that identifying and prosecuting insider trading d irectly was too d ifficult. Although it recog
n ized that section 16 was not an a irtight provision against insider trading, Congress believed
the Exchange Act would encourage voluntary abstention from i nsider trading.
Because i t is difficult to draw a clear line as a matter of law between truly
i nside information and i n formation generally known by the better-informed in
vestors, the most potent weapon against the abuse of inside information is full
and prompt publicity . . . . The Committee i s aware that these requirements
are not air-tight and that the u nscrupulous i nsider may sti l l , within the law,
use inside i nformation for his own advantage . . . .
H.R REP. No. 1 383, 73d Cong. , 2d Sess. 1 3 ( 1 934 ) . B u t see The!, supra (argu ing that section
16 is not aimed at regulation of i nsider trading but rather focuses on preventing manage
ment manipulation of corporate events to create trading opportunities) .
Section 20A, although addressing i nsider trading, does not contain any direct lim itation
on trading; it simply provides a private cause of action for persons who trade contemporane
ously i n the market with inside traders. The section does not make insider trading illegal.
I nstead, it bootstraps private civil liability onto other statutory or regulatory provisions. See
1 5 U. S.C. § 78t- l ( 1 988) . See generally William K . S . Wang, The "Cont empnraneous"' Tra d
ers Who Can Sue a n Inside Trader, 38 H ASTINGS L.J. 1 1 75 ( 1 987) (discussing development
of case law regard ing private actions by contemporaneous traders).
'0
Section 10(b) provides:
It shall be unlawful for any person, directly or indi rectly, by the use of any
means or instrumentality of interstate commerce or of the mails, or of any
facil ity of any national securities exchange-
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Neither section 1 0 (b ) n o r Rule 1 0 b - 5 explicitly refers t o insider
trading. Instead, the SEC and the courts have concluded22 that the
language prohibiting deception and fraud bars insider trading.
Based on the reasoning accepted by the S upreme Court, insider
trading is a fraudulent omission and therefore securities fraud . 23
Under the common-law tort of fraudulent misrepresentation,
upon which much of the C ourt's interpretation of Rule 1 0b - 5 is
based , liability may be premised on omissions-the failure to
speak-as well as affirmative misstatements.24 An omission i s de
ceptive or fraudulent under Rule 1 0b - 5 , however, only under c ir
cumstances in which the defendant has a duty to speak . 2 5 S omeone
who trades on the basis of inside information has not dece ived an-
( b ) t o use or employ, i n connection with the purchase o r sale of any security
registered on a national securities exchange or any security not so registered ,
any manipulative or deceptive device or contrivance in contravention of such
rules and regulations as the Commission may prescribe as necessary or a p pro
priate i n the public interest or for the protection of i nvestors.
15 U.S.C. § 78j ( b ) ( 1988) .
"' SEC Rule l Ob-S p rovides:
I t shall be unlawful for any person, d irectly or i n directly, by the use of any
means or i nstrumentality of i nterstate commerce, or of the mails or of any
facility of any national securities exchange,
( a) To employ any device, scheme or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a
material fact n ecessary in order to make the statements made, in light of the
circumstances under which they were made, not m isleading, or
( c ) To engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
17 C . F.R. § 240. 1 0b-5 ( 199 1 ) .
22
O n e commentator describes t h i s process by stating that, in t h e Cady, R o berts opinion,
" C hairman Cary discovered [Rule lOb -5] prohibited insider trad ing. " S tephen M . Bain
bridge, The Insider Trading Prohibition: A Leg a l a n d Economic Enigma, 38 U FLA. L. REv.
35, 38 ( 1 986) (emphasis added) .
23 C h iarella v . U n i ted States, 445 U . S . 2 2 2 , 2 26-30 ( 1980 ) .
2 ' T h e original Senate b i l l t h a t formed the basis of t h e 1 934 Exchange Act prohibited the
use of false or misleading statements and defined "statement" to include "any omission to
state a material fact." S. 3420, 73d Cong., 2d Sess. § 9 ( a ) (4) ( 1 934). Congress omitted this
provision from the final statute, deeming it superfluous. See H.R REP. No. 1383, 73d Cong. ,
2d Sess. 32 ( 1934).
20
See, e.g., Chiarella, 445 U.S. at 228 ("One who fails to d isclose material i n formation
prior to the consummation of a transaction commits fraud only when he is under a duty to
do so."); Affiliated Ute C itizen s v. U n i ted States, 406 U . S . 1 28, 154 ( 1972) ("The obl igation
to disclose and [ the] withholding of a material fact establish the requisite causation in
fact. " ) .
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1 87
yone unless he had a duty to disclose the information prior to trad
ing. Under circumstances in which the trader has a duty to make
such disclosure , trading in the absence of the disclosure constitutes
securities fraud. 26
The requirement of a duty has resulted in some confusing judi
cial rhetoric. The courts have developed two lines of reasoning
whereby a trader may be said to breach a duty by trading on non
public information. These lines of reasoning, which form two dis
tinct bases for liability, are commonly known as the classical, or
traditional, theory and the misappropriation theory.
T H E CLASSICAL THEORY OF I N SIDER TRADING
A.
Classical insider trading theory has its roots in the regulation of
trading by true corporate insiders.27 Insiders are privy to confiden
tial inside information about their corporation by virtue of their
corporate responsibilities. In addition, corporate insiders perform
these responsibilities subject to a fiduciary duty which has its ori
gins in statute and common law.28 In 1 96 1 , the SEC decided that
the acquisition of nonpublic information by insiders gave rise to an
obligation either to refrain from trading on that information or to
disclose it.29 In the landmark decision In re Cady, Roberts & Co. , 3 0
26
It is generally assumed that an issuer itself cannot trade while in possession of material
nonpublic i n formation. See, e.g. , Laventhall v. General Dynamics Corp. , 704 F.2d 407, 4 1 2
( 8th Cir. ) , cert. denied, 464 U.S. 846 ( 1 983); Western Hemisphere Group v. Stan West
Corp., [ 1984-85 Transfer B i n der] Fed. Sec. L . Rep. ( C C H ) �I 9 1 ,858, at 90,279 (S.D.N.Y.
1984); see a lso Donald C. Langevoort, Insider Trading and the Fiduciary Principle: A Pos t
Ch iarella Rest a t e m e n t , 70 C A L L. R E v . 1 , 20-21 & n.77 ( 1 982) (comparing fiduciary obliga
tions of issuer to those of corporate officers and employees) ; infra note 29 ( discussing cases
in which courts found i n sider's fi d uciary d u ty to others justified liability ) . Under the Ameri
can Law I nstitute's proposed Federal Secur ities Code, the term " i nsider" for purposes of
i nsider trading obligations is defined to include the issuer. FED. SEc. ConE § 1 603 ( b ) ( 1 980) .
27 The term " insider" has not been defined b y statute or b y the Supreme Court. See 3
BROMBERG SECURITIES LAw § 7 . 4 ( 6 ) ( b ) at 1 80 - 8 1 & n . 1 6 9 . 1 ( 1 969). Section 1 6 ( b ) classifies
d irectors, officers, and 10% stockholders as insiders, 15 U . S .C. § 78p ( a ) & ( b ) ( 1 988 ) , but its
language is not necessarily applicable to Rule 10b-5. See M os s v. Nlorgan Stanley Inc., 7 1 9
F . 2 d 5, 1 0 n.8 (2d C i r . 1 983) ("Ordinarily, 'insi ders' i nclude such corporate figures a s d i rec
tors and vice presidents, persons who have access to confidential corporate i n formation and
therefore owe a duty to a corporation's shareholders not to trade on that information. "),
cert. denied, 465 U . S . 1 025 ( 1984 ) .
28
See, e.g. , WILLIAM L. C ARY & MELVIN A EISENBERG. CASES AND MATERIALS ON CoRPORA
TIONS 47 1-548 (6th ed. 1 990 ) ( describing development of common- law and statutory fiduci
ary duties of insiders) .
'" in re C a d y Roberts & Co., 40 S.E.C. 907, 9 1 1 ( 1 96 1 ) . Prior to 1961, there had been a
.
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[ Vol. 26: 1 7 9
188
the Commission held that corporate insiders who receive inside in
formation by virtue of their p osition have a duty to disclose the
information to persons with whom they deal ( or to the public at
large) or to refrain from trading. 31 A failure to adhere to the "dis
close or abstain" rule constituted fraud and hence violated Rule
lOb-5.32
The courts have accepted the classical theory of insider trad
ing.33 In Chiare lla u . United States, the Supreme Court adopted
the Cady, Roberts rationale that insider trading can violate Rule
lOb-5 as a fraudulent omission or fai lure to disclose but explained
that liability must be premised on a duty to disclose.34 The C ourt
few court decisions that found i n s i d e r trading i llegal as a violation o f e i t h e r R u l e 1 0b-5 o r
state comm o n - law doctri n es . One of the b e s t k n o w n is Speed v. Transamerica Corp., 99 F .
S u p p . 8 0 8 (D. Del. 1 951), i n w h i c h C h i e f Justice Leahy permitted recovery u n d e r Rule 1 0 b - 5
b y m i nority stockholders of t h e Axton -Fisher Tobacco Company w h o w e r e bought out b y
the majority stockholder, Transamerica, a t a n unfairly l o w price. Transamerica had i n for
mation, which i t did not disclose to the other stockholders, that Axton-Fisher's tobacco in
ventory was greatly undervalued. /d. at 8 1 2. Speed was not technically an insider trading
case; liability was premised on a fraudulent failure to d isclose, which was actionable because
of Transamerica's fiduciary duties as majority stockholder. Id. at 828.
Additionally, the transaction i n Speed was a face-to-face transaction so there was n o n eed
for the court to consider the general duties of a n insider to the marketplace based o n the
possession of superior i n formation. In general, j udicial decisions during this p e riod i mposed
insider trading l iability only in circumstances that involved face-to-face transactions be
tween the insider and those to whom the insider owed fiduciary duties, typically stockhold
ers. Bainbridge, supra note 22, a t 3 7 - 38.
See also In re Ward La France Truck Corp . , 13 S . E . C . 373, 381 (1943), in \vh i c h , i n one of
the first SEC opinions i n terpreting Rule 10b-5, the Commission reached the same conclu
sion as the Transamerica court and held that insiders who purchased stock o n behalf of the
issuer without d isclosin g material i n formation to the stockholders with whom they traded
violated the rule. Aga i n , l iability was based on the fiduciary obligations of the issuer and i ts
officers to stockholders. "The failure to [ disclose] placed shareholders at an u n fa i r d isadvan
tage in dealing with their own corporation and those i n control . " !d. at 380- 8 1 .
' 0 40 S . E . C . 907, 9 1 1 ( 1 96 1 ) .
:n
Jd.
:\2 I d. at 9 1 :3.
"" See, e.g. , SEC v. Texas Gulf Sulphur Co., 401 F.2d 8:33, 848-49 ( 2d Cir. 1 968) (en bane)
(" [A] nyone in possession of material i nside i n formation m ust either d isclose it . . . or . . .
must abstain from trading in or recommending the securities . . . ") , cert. denied, 394 U . S .
9 7 6 ( 1 969).
3' 445 U.S. 222 (1980). Notably, according to the Supreme Court, Chiarella was the first
case in which criminal l iability was i mposed upon a defendant for insider trading. !d. at 235
n.20. Chiarella involved the prosecution of a financial printer who deciphered the identities
of targets of upcoming takeover bids from documents h e received for printing. W ithout dis
closing the information he had obtai ned, C hiarella purchased the stock of the target compa
nies before the takeover attempts were made public. United States v. Chiarella, 588 F.2d
1358, L162 (2d Cir. 1978), reu'd, 445 U . S . 222 (1980).
.
1 99 1 ]
INSIDER TRADING
1 89
stated that this duty may arise "from a relation�hip of trust and
confidence between parties to a transaction."35 It concluded that
this type of relationship exists between corporate insiders and
stockholders, based on the insiders' obligation to put the stock
holders' welfare before their own.36 The Court consequently re
versed Chiarella's conviction on the grounds that he neither was a
corporate insider nor owed any duties to the stockholders of the
corporation in whose stock he traded.37
One obvious difficulty with the classical theory is that it fails to
explain why the fiduciary relationship between insiders and the
corporation gives rise to a duty in the financial marketplace to
speak. In other words , why is trading by a corporate fiduciary de
ceptive, and who is deceived? Some scholars have attempted to
base the insider's duty to disclose on common-law principles of
agency. 38 A corporate insider receives inside information in order
to effectuate his role as agent for the corporation. 39 Agency law
prohibits an agent from obtaining a personal benefit in the course
of serving as agent.40 Under traditional agency rules, any profit an
3°
Chiarella, 445 U.S. at 230.
The Court stated that a corporate i nsider owes a duty to present stockholders because
of his fiduciary obligations to such stockholders ; thus, the i nsider who purchases stock from
such stockholders on the basis of i nside i n formation has breached this fiduciary duty. !d. at
227-28. The Court concluded that it would be irrational to allow insiders to abuse their
position by selling stock based on inside information , even though sales would not breach
any duty to existing stockholders. !d. at 227 n.8.
3 7 Id. at 231-35. The Court expressly rejected the argument that anyone who has i nside
i n formation owes a general Cady, R o berts duty to the marketplace. For a detailed analysis
of the opinions i n Chiarella and the bases for regulation espoused by the various Justices,
see Frank H. Easterbrook, Insider Trading, Secret Agen ts, Evidentiary Privileges and t h e
Produ ction o f Information, 1981 SuP. C T . REv. 309, 314-30.
"" E.g. , Langevoort, s upra note 26, at 1 9-21.
39 See James D. Cox, Insider Trading a n d Contracting: A Critical Response to t h e Chi
cago Sch o o l , 1986 DuKE L.J. 628, 659 ( noting expectation of stockholders that insider will
concentrate on developing corporation's i nterests rather than his own private investment
agenda).
'0 See RESTATEMENT (SECOND) OF AGENCY § 388 & cmt. C (1957); see a lso RESTATEMENT
(SECOND) OF AGENCY § 395 (1957).
Unless otherwise agreed, an agent is subject to a duty to the principal n o t to
use or to communicate i n formation con fidentially given him by the principal or
acquired by him during the course of or on account of his agency or i n viola
tion of his d u ties as agent, i n competition with or to the i njury of the principal,
v n h i s own a c c o u n t or on b e h a lf o f anoth er, a lthough such information does
not relate to the transaction in which he is then employed , un less the i n forma
tion is a matter of general knowledge.
!d. ( emphasis added). This common- law rule is designed to remove the agent's temptation
36
1 90
[ Vol. 26: 1 7 9
agent receives i n the course of his agen cy is received in trust for
the principal . 4 1
Applying agency principles t o insider trading is problematic,
however, because agency law does not generate an obligation to the
trading counterparty or to the market. R ather, agency law s uggests
that a corporate insider is unjustly enriched by making use of cor
porate information for his personal benefit and that any trading
profits are rightfully the property of the owner of the informa
tion-the corporation.42 This unjust enrichment takes place,
though, whether or not the insider discloses the infor.m ation prior
to trading. M ore importantly, unjust enrichment is not the legal
equivalent of deception. An agent who receives a personal benefit
and thereby enriches himself unjustly does not necessarily deceive
his principal.43 Thus, the agency analogy neither supports the
Cady, Roberts duty to disclose or abstain nor explains how the
breach of that duty violates section 1 0 ( b ) .
Another possible explanation for the Cady, Roberts duty i s a
level-playing-field notion of the securities markets. This approach
assumes investors are entitled to equal access to securities i nfor
mation.44 Any informational inequality based on unequal access,
to act contrary to his principal's i n terests i n order to obtain a personal benefit. See A llison
G . Anderson , Conflicts of Interest: Efficiency, Fairness a n d Corporate Struct u re, 2 5 UCLA
L. REv. 738, 758-60 ( 1978) ( discussing fi d uciary d uties as safeguards ) ; Gareth Jones, Unjust
Enrichment and the Fiduciary 's Duty of Loyalty, 84 L A W Q REv. 4 7 2 , 486-87 ( 1 968) (dis
cussi n g public policy issues regard i n g such a rule ) .
" E.g., Tarnowski v. Resop, 5 1 N . W . 2 d 8 0 1 , 8 0 2 ( M i n n . 195 2 ) . T h e extension of t h i s prin
ciple to corporate law has resulted in the development of the corporate-opportunity doc
trine, under which a corporate insider who receives a business opportunity i n the course of
his employme n t may not appropriate the opportunity for his persona l gain. T h e most fa
mous application of the corporate-opportu n i ty doctrin e i n volved the case of G u t h v. Loft,
I n c . , 5 A . 2d 503, 5 1 1 (Del. 1939) , in which C harles Guth, the president of L oft, a m anufac
turer and distributor of fountain beverages, attempted to acquire and explo i t the P epsi-Cola
formula and trademark for h i s persona l benefit. The Delaware Supreme Court held that the
opportunity belonged to the company a n d could not be taken by Guth personally. !d. at 5 1 5.
Even i n cases involving the m isappropriation of a corporate opportun ity, however, the i n
s i d er's conduct m a y be ratified by t h e corporation. E.g . , K l i n icki v. Lundgren, 6 9 5 P . 2 d 906,
920 (Or. 1985) .
' " See supra note 40 ( discussi n g common law of agency a s reflected i n Restatement (Sec
ond) of Agency ) .
"' S e e RK'TATEMENT (SECOND) OF T R U STS § 2 0 3 ( 1 959) (stating trustee i s accountable for
any profit made by h i m arising out of administration of trust, even if p rofit d oes not result
from trustee's breach of trust) .
According to the Supreme Court, the SEC has argued for a parity-of-i n formation stan
d ard. See, e.g , Dirks v . SEC, 463 U.S. 646, 657 ( 1983) ( " [ T ] h e SEC's theory of tippee liabil·I I
1
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INSIDER TRADING
191
such as the receipt o f inside information, compels a duty t o dis
close or abstain. The deception, under this approach, is of others
trading in the security. The level-playing-field concept is based on
the view that traders should not be able to take advantage of infor
mation they know cannot lawfully be obtained by others.45 The
duty to disclose or abstain is premised on principles of fairness: it
is unfair for corporate insiders to trade on the basis of information
to which they have access solely because of their p osition as
insiders. 46
The third potential source for the insider's duty lies in the cor
poration's own duty of disclosure. Trading47 by the corporation it
self, while in possession of material nonpublic information , would
constitute securities fraud because of the issuer's duty, under the
federal securities laws, to disclose all material inform ation relevant
to investors before trading.48 When corporate insiders obtain infor
mation from the corporation, which itself may not lawfully trade,
they arguably inherit the corporation's duty to disclose.
The foregoing discussion focuses on the absence of an identifi
able source for the Cady, Roberts duty. The second problem with
the classical approach is its failure to articulate the beneficiary of
that duty, i . e . , the person(s) to whom the duty is owed. Even if one
ity [in both Dirks and Chiarel l a ] appears rooted in the idea that the antifraud provisions
require equal i n formation among all traders . " ) . Strictly speaking, this characterization is not
true. No one woul d suggest that all players i n the investment markets have equal i n forma
tion. See Jonathan R . Macey, From Fairness t o Contract: The New Direction of the Ru les
Against Insider Trading, 13 H o FSTRA L. REv. 9, 1 6 - 1 7 ( 1 984) (discussing i nevitable advan
tage of one party over the other i n a securities trade) . The level -playing-field standard is
based on equal access to i n formation-a parity-of-access standard. See SEC v . Texas Gulf
Sulphur Co. , 401 F.2d 833, 848-49 ( 2d Cir. 1 968) (en bane) ("The Rule is based in policy on
the justifiable expectation of the securities marketplace that all investors trading on imper
sonal exchanges have relatively equa l access to materia! information.") ( emphasis added ) ,
cert denied, 394 U.S. 976 ( 1 969).
' 6 This concept appears to be the basis of the Cady, Roberts decision. See Brudney, supra
note 1 3 , at 353-54.
4 6 More broadly stated, i t may be viewed as u n fair for anyone to trade on the basis of
information that is not publicly available. See infra notes 185- 1 94 and accompanying text.
47 The disclosure obligations of a nontrading corporation are not clear. The courts have
suggested that, under certain circumstances, even a nontrading corporation may be l i able
for fai lure to disclose material developme n ts that would have a significant impact on stock
price. See, e.g. , Basic, Inc. v. Levinson, 485 U . S . 224, 230-41 ( 1 988) (discussin g when corpo
ration must d isclose preliminary corporate-merger d iscussions and suggesting that failure to
discl ose such discussions may constitute fraudulent omission ) .
4 6 See supra note 26.
192
[Vol. 26: 1 7 9
accepts the premise that a corporate insider has a common-law
duty to abstain from using inside information for personal trading,
it does not necessarily follow that the duty is to the market. The
fiduciary duty viewed by the Chiare lla C ourt as the source of the
insider's obligation to disclose or abstain is a duty to the corpora
tion, not to the market at large.49 The breach of a fiduciary duty to
the issuer, however, does not obviously constitute the deception re
quired for a violation of section 1 0 ( b ) . Moreover , the case law
under section 1 0 ( b ) makes clear that every violation of a common
law duty does not give rise to a violation of the statute's antifraud
provisions.5° Congress clearly did not intend, through the enact
ment of section 1 0 ( b ) , to federalize common-law doctrines of fidu
ciary duty.51
Accordingly, the breach of duty must, in some way, implicate the
p olicies behind the federal securities laws. The violation of an
agency-law based principle of fiduciary duty fails to do so. If the
insider's trading is wrongful because of his fiduciary obligations to
the corporation , it is not therefore deceptive or fraudulent. The
corporation has not been deceived in connection with the p urchase
or sale of a security. The courts have attempted to deal with this
problem by inferring a fiduciary duty to the corporation's stock
holders. 52 A corporate insider has a direct fiduciary d uty to the
corporation ; he also has a fiduciary duty to the corporation's stock
holders. When an insider trades with stockholders without disclos
ing his superior information, the insider has deceived them in vio-
49 See C h iarella v. United States, 445 U . S . 2 2 2 , 2 3 1 -32 & n. 1 4 ( 1980) (rej ecting court of
appeals' theory that Chiarella's position or access generated duty to d isclose i n formation to
others i n market) .
60
See, e.g. , Santa Fe I ndus. v. Green, 430 U . S . 462, 473-74 ( 1 977) ( holding statute bars
only "manipulative or deceptive" conduct).
" See id. at 479 ( rejecting application of securities laws that would have federal courts
applying a " ' federal fi duciary principle' under Rule 1 0 b - 5 " ) .
" E.g . , Chiarella, 4 4 5 U .S . at 2 2 7 . This reasoning suggests that i n s i d e r trading i n debt
securities would not violate Rule 10b-5, at least under classical insider trading theory. The
applicability of the prohibition to trading i n debt securities has not been d e fi n itively ad
dressed by the courts. See SEC Staff Examining Jun k Bonds for Insider Trading, Breeden
Says, 23 Sec. Reg. & L. Rep. ( B N A ) No. 1 5 , at 525 (April 1 2 , 1 99 1 ) (quoting Chairman
B reeden's statement to Senate Banking Comm ittee C hairman Donald Riegle that applicable
theories have not yet been tested i n courts ) . Some opinions appear to have assumed, with
out analysis, that such trading is prohibited. See, e.g. , U n ited States v. Milken, 7 59 F . Supp.
109, 1 22-23 (S.D.N.Y. 1 990) ( fi nding defendant d i d not receive material nonpublic i n forma
t i o n but assu mir.g t h a t l i a b i l i t y could be b a s e d u p o n defendant's trades i n corp o rate bonds ) .
199 1 ]
INSIDER TRADING
193
lation of this fiduciary duty.53
It is not immediately obvious why the existence of a corporate
law fiduciary duty makes the insider's trading with the corpora
tion's stockholders deceptive. Apparently, the deception stems
from a higher duty of disclosure or a duty of absolute fairness aris
ing from the fiduciary relationship. For example, if the fiduciary
relationship generates a duty of objective candor, the stockholder,
as beneficiary of this duty, may expect that when an insider trades
with stockholders, the insider has disclosed all material informa
tion. If the insider does not disclose all material facts , the stock
holder is deceived.
One legal source for a greater duty of disclosure in the fiduciary
relationship is the special facts doctrine/4 an exception to the gen
eral principle that there is no duty of absolute disclosure.'>5 If the
parties to a transaction stand in some confidential or fiduciary re
lationship, dealings between them require the "utmost good faith,
and full and fair disclosure of all material facts. "06
An alternative source for a greater duty of disclosure is the law
of trusts. P articularly in older cases, the position of a corporate
insider has been analogized to that of a trustee. 57 The law of trusts
governs transactions between fiduciary and beneficiary. In such
transactions, it imposes upon the trustee a duty of the " utmost
fairness" to the beneficiary, including disclosure of all information
known to the trustee. 58 Again, the stockholder as beneficiary would
"'' See Chiarella , 445 U.S. at 2 27 ( " [T ] he relationship between a corporate insider and the
s tockholders of his corporation gives rise to a disclosure obligation. " ) .
" S e e id. a t 228 n . 1 0 ; Langevoort, supra note 26, a t 4 - 5 .
' � S e e W. P A G E KEETON E T AL., P ROSSER A N D KEETON O N T H E L A w O F ToRTS § 1 0 6 , a t 7 3 7 3 8 ( 5th e d . 1 984) (noting t h a t modern cases find no general duty t o d isclose material facts ) .
06
Id. at 738-39. Traditionally, the special-facts doctrine did not apply to transactions
that took place on organized stock exchanges. See, e.g. , HENRY G . MANNE, I NSIDER TRADING
AND THE S TO C K MARKET 23-24 ( 1 966) .
67 See, e.g. , O liver v. O liver, 1 1 8 Ga. 362, 367, 45 S.E. 232, 234 ( 1 903) (holding that officer
or director is " a quasi trustee as to the shareholder's i nterest i n the shares"); Stewart v.
H arris, 77 P. 277, 279 ( Kan. 1 904) ("The managing officers of a corporation are not only
trustees i n relation to the corporate entity and the corporate property, but they are also to
some extent and i n many respects trustees of the corporate shareholders . " ) ; People ex rel.
Manice v. Powel l , 94 N.E. 634, 637 ( N . Y . 1 9 1 1 ) ("The relation of the directors to the stock
holders is essentially that of trustee and cestui que trus t . " ) .
'" S e e GEORGE T BoGERT, TRUSTS § 9 6 , at 3 4 8 (6th ed. 1 987 ) :
If a trustee enters into a transaction with a beneficiary relating t o the inter
est of the beneficiary under the trust, the trustee owes the benefi ciary a duty
to display the utmost fairness, which ordinarily involves disclosure to t h e ben-
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[Vol. 26: 1 7 9
expect the insider t o disclose all material facts unknown t o the
stockholder.
Finally, the insider's duty can be viewed not as a disclosure obli
gation but as a duty of overall or objective fairness. This duty may
be linked to the corporate -law duty of loyalty, under which an in
sider may not compete with the corporation or engage i n transac
tions in which he has a personal interest unless those transactions
are objectively fair to the corporation and its stockholders. 59
Transactions in which the insider has a personal stake present a
special risk that the insider will abuse his fiduciary position. 6 0
Under this standard of objective fairness, an insider who fails to
disclose material information prior to trading with stockholders
has misled those stockholders into entering an u nfair transaction.
The foregoing explanations provide a logical basis for finding
that corporate stockholders have been deceived when an insider
buys their stock ( or sells them additional stock) without disclosing
information obtained by virtue of the insider's p osition. Although
the use of the fiduciary relationship to extend the insider's duties
to a class of intended beneficiaries of the securities laws is widely
accepted,61 it applies only to trades between an insider and stock
holders of the insider's corporation. It is thus one-sided in opera
tion. A corporate insider who purchases stock is trading with pre
sent stockholders and arguably defrauds those to whom he owes a
fiduciary obligation. On the other hand , a corporate insider who
sells stock is dealing with someone who has no current relationship
with the corporation. In this second case, the fiduciary obligations
of the insider to the corporation generate no duty to disclose or
abstain.62
eficiary of a l l relev a n t facts which are unknown to the beneficiary . . . .
The doctrine applies to a l l fiduciaries and also to persons in a confidential
relationship . . . .
(emphasis added ) .
•• See, e.g , Lewis v . S.L. & E . , Inc., 6 2 9 F . 2 d 764, 768-70 ( 2 d C i r . 1 980) ; Scott v. M u l t i
Amp Corp . , 3 8 6 F. S u p p . 4 4 , 6 8 ( D . N.J. 1974 ) .
60
See Anderson, supra note 40, at 760-61 ( noting situations in which l i kelihood of cheat
ing is particularly great ) .
6 1 Chiarella v. U n i ted S tates, 445 U.S. 222, 227 n.8 ( 1980 ) .
6 � T h e Supreme Court's o n ly effort at addressing this dilemma is contained i n foo tnote
eight of Chiarell a , in which the CoUit c ites the reasoning of Judge Learned Hand that " i t
would b e a sorry distinction to allow [ th e insider] to use the advantage o f h i s position t o
i nduce t h e buyer i n t o t h e position of a beneficiary although he was forbidden to d o so once
the buyer had become one . " !d . ( q uoting G ratz \·. C laughton, 187 F.2d 46, 49 (2d C ir. ) , cert .
199 1 ]
INSIDER TRADING
1 95
Moreover , Rule lOb-5 requires that the fraud occur in connec
tion with the sale or purchase of securities.63 This requirement has
two elements: the fraud must affect the financial m arketplace,64
and the plaintiff must be a defrauded purchaser or seller.65 It is the
latter element that is of significance here, for as the Court found in
Blue Chip Stamps v . Manor Drug Stores , Rule lOb-5 is aimed only
at "injury suffered 'in connection with the purchase or sale' of se
curi ties. "66 Indeed, the Blue Chip Court specifically found that two
classes of p laintiffs to whom corporate insiders owed fiduciary du
ties lacked standing to recover under lOb-5 for the insiders' fraud
because there was an insufficient connection between the fraud and
a securities transaction.67
Thus, in B lue Chip, the C ourt specifically rej ected the notion
that every fraud or breach of fiduciary duty practiced by a corpo
rate insider upon shareholders constitutes securities fraud. The
Court restricted the class of actionable claims under lOb-5 to those
in which the fraud resulted in the purchase or sale of stock by the
victim. 68 As the next section will demonstrate, this connection be-
denied, 3 4 1 U . S . 9 2 0 ( 19 5 1 ) ) . A lthough the distinction m a y w e l l be a "sorry" o n e , i t is d i ffi
cult t o understand h o w this reasoning gives rise t o a duty by insiders not t o s e l l their stock
on the basis of inside information. Importantly, the opinion of Judge Hand to which the
Chiarella Court refers addressed the constitutionality of section 1 6 ( b ) , not the obligations
imposed by section 1 0 ( b ) . See Gra t z , 187 F.2d at 49.
63 17 C . F. R . § 240. 1 0b-5 ( 199 1 ) .
•• A s Judge Friendly explained:
The purpose of § 1 0 ( b ) and Rule lOb-5 is to protect persons who are deceived
in securities transactions-to make sure that buyers of securities get what
they think they are getting and that sellers of securities are not tricked i n to
parting with something for a price known to the buyer to be inadequate or for
a consideration known to the buyer not to be what it purports to be.
Chemical Bank v . Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir.) (emphasis added),
cert. d e n i e d , 469 U . S . 884 ( 1 984) ; s e e a lso Hemming v . Alfin Fragrances, Inc., 690 F . S).ipp.
239, 244 (S.D.N.Y. 1 988) (distinguishing certain consumer-oriented statements as not invok
ing antifraud provisions of federal securities laws because not directed to i nvestors) .
65 S e e B lue Chip Stamps v. Manor D r u g S tores, 4 2 1 U .S. 723, 755 ( 1 97 5 ) (refusing stand
ing to defrauded i nvestors who did not trade on basis of misrepresentations) .
• • ! d . at 733; cf. U n i ted States v . Naftalin, 4 4 1 U . S . 768, 772-76 ( 1979) (refusing t o limit
application of section 1 7 ( a) ( l ) of Securities Act of 1 933 to frauds injuring i nvestors, on basis
that i nvestor protection was not sole purpose of Securities Act ) .
6 7 The Court's holding i n Blue Chip denies standi ng t o present stockholders o f a corpora
tion who are defrauded through management m isrepresentations into not selling their stock
and to stockholders ( and creditors) who suffer a loss in the value of their stock as a result of
the insiders' fraudulent practices. See Blue Chip , 4 2 1 U . S . at 737-38.
"8 ! d . at 723. O n this basis the Southern D istrict of New York dism issed insider trading
charges i n Uni t e d S t a t es u. Newman, holding that the defendant could not be l iable for
1 96
[ Vol. 26: 1 79
tween the fraud and the securities transaction has been completely
eviscerated in cases applying the misappropriation theory.69 Even
under the classical doctrine of insider trading, however, the con
nection between the insider's fraud and the victim 's i njury is not
altogether clear.
Although courts have found that trading by an insider or tippee
furnishes the necessary p ur chase or sale to satisfy the " in connec
tion with" requirement, they have not required any tie between
the securities transaction and the breach of duty. 7 0 The problem
lies in distinguishing between an insider who sells confidential cor
porate i nformation to a competitor and one who sells such infor
mation to a prospective trader. The misappropriation of informa
tion from the company is the same, as is the breach of the insider's
fiduciary duty. Indeed, the damage to the company is likely to be
greater in the former case. Yet, only the second situation violates
insider trading law, and that violation results from the fortuity
that the recipient of the information intends to use it in the securi
ties markets.
In addition, unlike traditional securities fraud, there is no direct
relationship between the corporate insider's breach of a duty-the
decision to engage in insider trading-and the transaction that
causes harm to other stockholders-the ' ignorant' trade.71 The cor-
insider trading unless he defrauded a p urchaser or seller of securities. Uni ted States v . New
man, 664 F . 2d 1 2 , 1 9 ( 2d Cir. 1 98 1 ) , c e r t . denied, 464 U.S. 863 ( 1 983 ) . The Second Circuit
reversed the dismissal. !d.
6 9 For a d iscussion of the misappropriation theory, see infra notes 80- 1 2 9 and accompany
ing text.
70 The insider's ( or tippee's) trading is the securities transaction w i th which the fraud is
connected. See, e.g . , SEC v. Materia, 745 F.2d 197, 203 ( 2d Cir. 1 984), cert. denied, 471 U . S .
1 0 5 3 ( 1985) ; Newman, 664 F . 2d at 1 8 .
7 1 Cf. infra note 185 ( discussing commentators' v iews of whether insider trading d irectly
h arms contemporaneous traders ) . Some commentators have argued that insider trad ing
causes market makers and specialists to adjust the spread for stocks i n which insider trading
is l ikely. E.g . , W il liam J. Carney, Signaling and Causation in Insider Trading, 36 CATH. U .
L . REV. 8 6 3 , 888-9 1 ( 1 987 ) .
If insider trading i nduces a n y trading, it i s l ikely t o i nduce copycat trades b y investors
who, although not privy to the inside i n formation directly, hope to take indirect advantage
of such i n formation by duplicating the trades of insiders. This process has been described as
"trade decod ing.'' See Gilson & K raakman, supra note 1 1 , at 5 7 3 ( describing widespread
trading practice by uninformed traders of duplicating trading by insiders based on assump
tion that insiders are l i kely to possess valuable information) .
The trading by statutory corporate insiders (officers, d irectors, and 10% stockholders) as
reported to the government through the filing of Schedule 1 6A is made available to the
199 1 ]
INSIDER TRADING
197
porate insiders who purchased stock on the basis of inside informa
tion in SEC v. Texas G u lf Sulphur Co. ,72 for example, did not in
duce present stockholders to sell their stock but simply bought
stock for themselves before any public announcement of the dis
covery of extraordinarily rich mineral deposits.73 Those stockhold
ers who decided contemporaneously to sell did so based on extra
neous factors and in ignorance of the existence of insider trading.
Their decision to sell the stock for a price that did not reflect the
mineral deposit opportunity was the d irect cause of their loss and
was, presumably, a decision they would have made even if the in
siders had stayed out of the market.74 Accordingly, while the insid
ers may have breached a duty to the company by making a per
sonal profit with corporate inform ation, it is difficult to see any
relationship between that breach and the harm suffered by the
selling stockholders, who supposedly were the defrauded victims.75
There is another problem with premising the fraudulent aspect
of insider trading on the insiders' fiduciary duties to the corpora
tion's stockholders: the premise is not implicated unless trading is
effected by a traditional insider and the insider trades in the secur
ities of his own corporation. For example, an insider, by virtue of
his inside position in corporation A, receives material inside infor-
public on a monthly basis i n the Official S um mary of Security Transactions and Holdings,
printed by the U.S. Government P rinting Office in Washington, D . C . A n umber of invest
ment newsletters, books, and da tabases are marketed on the premise that merely copying
the reported trading activities of corporate insiders is l ikely to produce superior returns.
E.g. , VICKERS WEEKLY INSIDER REPORT; THE INSIDERS' CHRONICLE ( a weekly publication of
American Banker-Bond Buyer edited by William Mehlman); AARON B . FEIGE:-J & DoN
CHRISTENSEN. INVESTING WITH THE INSIDERS LEGALLY ( 1 988) ; cf. Dan G i voly & Dan Palmon,
Insider Trading and the Exp lo i t a t ion of Inside Informa t ion: Some Empirical Evidence, 58
J. Bus. 69, 71 ( 1 985) (suggesting that, because of copycat effect generated when insiders
trade, such trading may generate abnormal returns in absence of any m isuse of inside
information ) .
7 2 4 0 1 F.2d 833 ( 2 d Cir. 1 968) ( e n bane) , cert. denied, 394 U . S . 976 ( 1 969) .
'3 !d. at 847, 852-57.
'' See Carney, supra note 7 1 , at 886-9 1 (finding no causal relations h i p between unde
tected in s i d e r trading and harm to particular investors ) .
" Indeed, i t i s n o t Clear t h a t Texas G u l f Sulphur could itself have traded stock during the
time period in question, being in possession of material information that it had a duty to
disclose t o stockholders i f it traded. See supra notes 26- 29. Thus, the d irect victim of the
insiders' breach of duty cou ld not suffer an injury through engaging in securities transac
tions. This d ivorce of the duty breached from the harm suffered is carried to an extreme by
the conte mporaneous traders provision of the Insider Trading and Securities Fraud En
forcement Act of 1 988, § 20A , 15 U . S . C . § 78t - 1 ( 1 988) . Section 20A permits investors who
trade con t e m poraneously with an i nsider to recover a private damage award. !d.
[ Vol. 26: 1 7 9
198
m ation concerning corporation B , such a s the fact that corporation
A is about to terminate its long-term sup plier/purchaser relation
ship with corporation B or that corporation A is planning a tender
offer for the stock of corporation B. Knowing that disclosure of
this information will have a substantial effect on the price of B's
securities, the insider trades i n the securities of corporation B.
Under the principles described above , the insider has not commit
ted securities fraud. Whether the insider buys or sells, his transac
tion is not with the stockholders of corporation A, to which he
owes a fiduciary duty, but with the stockholders or future stock
holders of corporation B, to which no such duty is owed.76
Trading of this type is frequently described as " outsi der trad
ing, " so denominated because the traders are outsiders with re
spect to the issuer of the securities they trade.77 Outsider trading
commonly occurs in connection with tender offers and other take
over transactions. Insiders of the acquiring company, for example,
knowing of the impending tender offer, may purchase stock in the
target company prior to public announcement of the offer. Out
sider trading also has been used to describe trading by persons
who are not traditional insiders but perhaps could be described as
market insiders based on their regular access to confidential infor
mation likely to affect market prices. This group includes securi
ties analysts , reporters , and financial printers.
Prohibition of outsider trading requires a theory of liability that
does not depend on a fiduciary relationship between the trader and
the issuer of the securities traded. It therefore demonstrates the
limitations of the classical theory. These limitations are illustrated
by the Court's finding in Chiare l la that the Cady, Ro berts duty to
disclose or abstain could not support Chiarella's conviction because
he had no fiduciary duty to the companies in whose stock he
traded.78 This decision generated dissatisfaction with the classical
theory as the sole basis for imposing liability for insider trading.
Although Chiare l la was a setba-ck , the SEC and the courts, most
76 See P h i l lips & Zutz, s u pra note 5 , at 85 ( a rgu i ng that fiduciary d u ty sta n d a r d res u l ts in
inabil ity to
apply section l O ( b ) and Rule lOb-5 to persons trading stock of one company
while e m p loyed at another company) .
based on information learned
" See SEC
v.
C lark,
9 15
F.2d
439, 443 (9th
who are ne ither i n s i d ers of t h e c om pan i es
Cir.
1 990)
( d e fi n i ng " o uts i d e r s ' ' a s " p e rsons
whose shares a;-e being tra ded, nor t i ppees o f such
insiders " ) .
78
Chiarella
v.
U n i ted States, 445
U . S . 222, 232-33 ( 1980)
r
1991]
INSIDER TRADING
199
notably the Second C ircuit,79 found within Chiare lla the seeds of
an alternative approach to insider trading: the misappropriation
theory.
B.
THE MISAPPROPRIATI ON THEORY
The misappropriation theory bases liability on the breach of a
duty other than the insider's fiduciary duty to his corporation.80 As
the Second C ircuit explained in SEC v. Ma teria, a person who mis
appropriates or steals confidential information defrauds the source
of the information.81 It concluded that the use of confidential cor
porate information for personal gain by an outsider is misappropri
ation. In Ma teria, the court held that a financial printer who had
engaged in wrongdoing similar to that of Chiarella had defrauded
his employer, not the target companies. This fraud on the source
was found by the court to be a sufficient predicate for an insider
7 9 SEC v. Materia, 745 F.2d 1 97 , 201 (2d Cir. 1 9 84 ) , cert. denied, 471 U.S. 1 053 ( 1985 ) .
Thus far, t h e only other circuits t o adopt t h e misappropriation theory a r e t h e Third, Roth
berg v. Rosenbloom, 7 7 1 F.2d 8 1 8 , 824 (3d Cir. 1985 ) ; the Seventh, SEC v . Cherif, 933 F.2d
403, 410 (7th Cir. 1 99 1 ) , cert. denied, No. 9 1 -605, 1 992 U . S . LEXIS 658 ( U. S . Jan. 27, 1992 ) ;
and t h e N i n t h , SEC v. C l a r k , 9 1 5 F.2d 4 3 9 , 4 5 3 ( 9 t h Cir. 1 990). T h e theory has been e m
ployed in several other circuits a t t h e d istrict court l e v e l . S e e , e.g. , SEC v. H urton, 7 3 9 F.
Supp. 704, 705 ( D . Mass. 1990 ) ; SEC v. Peters, 735 F . Supp. 1 505, 1520 (D. Kan. 1 990) ;
U n i ted States v. E lliott, 7 1 1 F. Supp. 425, 4 3 1 ( N . D . Ill. 1989 ) .
80
The Ninth C ircuit has described the elements of the m isappropriation theory as
follows:
Rule 10b-5 i s violated when a person ( 1 ) misappropriates material nonpublic
information (2) by breaching a duty arising out of a relationship of trust and
confidence and (3) uses that information i n a securities transaction, (4) regard
less of whether he owed any duties to the shareholders of the traded stock.
Clark , 915 F.2d at 443.
81
Ma teria, 745 F.2d at 201 ; s e e also Chiarella, 445 U.S. at 239-40 ( Burger, C.J., dissent
ing) (applying duty to d isclose o r abstain whenever informational advantage is obtained "by
some unlawful means" ) . Ma t eria involved the same factual scenario as Chiarella; notwith
standing efforts by clients to keep the identities of takeover targets confidential, Materia, a
copyholder for a financial printer, was able to ascertain the identities of the targets. Materia
p urchased stock i n the target companies and made substantial profits. Unlike C hiarella,
Materia was charged with trading on the basis of information that had been m isappropri
ated from his employer. lvfa t eria , 745 F.2d at 1 99-200.
lvfa teria was not the first Second Circuit decision to adopt the misappropriation t heory.
The concept that ins ider trading l iabi l i ty could be p redicated on the defendant's defraud ing
the source of the information was first adopted by that court in United States v. Newman,
664 F.2d 12, 18 (2d Cir. 1981 ) , cert. denied, 464 U.S. 863 ( 1 983 ) . The Second C i rcuit has
continued to apply t he misappropriation theory. See, e.g. , United States v . Grossman. 843
F.2d 78, 85-86 ( 2ci Cir. 1988), cert. d e n i e d , 488 U . S . 1 040 ( 1 989 ) .
200
[ Vol. 26: 1 7 9
trading conviction. 82
Fraud under the misappropriation theory is not premised upon a
duty to disclose or abstain. Indeed, the Ma teria court explicitly
rejected the argument that insider trading liability must be based
on a duty to disclose.83 Instead, the court found that the misappro
priation of confidential information which defrauds the source84
satisfies Rule 1 0b-5's requirement that the fraud operate " on any
person . ' ' 8 15
The separate opinions in Chiarella contain the seeds of the mis
appropriation theory. Justice Stevens's concurring opinion , which
provided the crucial fifth vote in Chiare lla , explained that the
Court had not addressed whether Chiarella's breach of a duty of
silence to his employer could serve as a basis of liability. 86 Simi
larly, both Chief Justice Burger's dissenting opinion and Justice
Brennan's opinion concurring in the judgment stressed that a
trader could violate Rule lOb-5 by trading on the basis of informa
tion that was improperly obtained.87 The Second C ircuit seized
upon the language in these opinions and expanded it. Eschewing
any requirement that the trader actually steal inside information,
courts have permitted prosecution under the misappropriation the
ory whenever the trader obtains or uses inside information in
breach of a " fiduciary or similar duty of trust and confidence. "88
The requirement of "a relationship of trust and confidence " re
flects the S upreme Court's language in Chiare l la.89
82
Materia, 7 4 5 F.2d at 203.
83 I d.
84
at 203.
v . Clark , 9 1 5 F.2d 439, 447 ( " [ O ] utsider trading liability is
premised on the common law principle that when a fiduciary profits from confidential i n for
mation that he had received because of his fiduciary status, he breaches a l egal duty to the
person or entity that e ntrusted him with the i nformation.") (quoting U n i ted S tates v. Reed,
6 0 1 F. Supp. 685, 700 (S.D.N. Y. ) , rev 'd in part on other grounds, 773 F . 2d 477 ( 2d Cir.
!d. at 2 0 1 -02; see a lso SEC
1 985) ) .
8' Ma teria , 7 4 5
86
F . 2d a t 2 0 1 .
Chiarella , 4 4 5 U.S. at 238 ( Stevens, J . , concurring) .
87 See id. at 239 ( B rennan, J . , concurring) (stating that Rule I Ob-5 is violated whenever
person improperly obtains or converts nonpublic i n formation to his own use and then trades
on i t ) ; id. at 243-45 ( Burger, C . J . , dissenting) ( i n formation obtained through theft, conver
sion, or other un lawful means cannot be used as basis for trading) .
ss
U n ited States v. Willis, 737 F. Supp. 269, 2 7 2 ( S . D . N . Y . 1990).
"" See Ch iarella , 445 U.S. at 230 ( predicating liability under section l O ( b ) for fraudulent
omission "upon a duty to disclose arising from a relationship of trust and confidence be
tween parties to a transaction") ( Powell, J., delivering the opinion of the Court).
�
j
•
1
l
'l
199 1 ]
INSIDER TRADING
201
The misappropriation theory, as employed by the Second C ir
cuit, imposes liability whenever a trader uses information in
breach of this duty of trust and confidence. It thus applies in situa
tions where the trader owes no fiduciary duty to the source of the
info rmation or to stockholders of the issuer of the security traded.
The district court decision in United Sta tes u. Reed demon
strates the degree to which this theory expands liability.90 The
court held that the breach of a relationship of trust and confidence
between family members was a sufficient basis for alleging fraud.
The indictment in Reed charged the following facts: Gordon Reed,
the father, was a director of a company that was the subject of
merger negotiations. Gordon Reed told his son, Thomas , of the
merger proposal before it was publicly announced. The son bought
stock on the basis of the tip.91 The court found that, although the
family relationship alone did not give rise to the necessary duty for
10b-5 liability, because the father had a long-standing pattern of
confiding in his son, there was sufficient evidence of a duty92 to
permit prosecution.9 3
Recently, the same court concluded that the relationship be
tween psychiatrist and patient was also sufficient to give rise to
1 0b-5 liability. In United States u. Wi llis , 94 the district court held
that the United States could prosecute a psychiatrist who breached
his doctor-patient duty of confidentiality by trading on informa
tion he received in the course of treating a patient,9 5 on the basis
90 601 F. Supp. 685 ( S . D . N . Y. ) , reu 'd i n p a r t on o t h e r grounds, 773 F.2d 477 (2d Cir.
1985).
9 1 Reed, 60 1 F . Supp. at 690-9 1 .
9 2 The court d i d not explain whether the confidential relationship gave rise to a duty to
disclose ( presumably it did not) , a duty to abstain from trading, or some other kind of duty
that made Reed's use of the i n formation improper.
93 Reed, 60 1 F . Supp. at 7 1 7 - 1 8 . Defendant Reed was ultimately tried before a j ury and
acquitted. John C . Coffee, Jr., The 'Chest man ' Case: Misappropria t ion, Rule 1 -fe-3, 202
NY L.J. 5, 33 n . 1 7 ( 1 989) .
9' 737 F. Supp. 269 (S.D.N.Y. 1 990).
9 0 The psychiatrist learned through his treatment of Joan Weill that her h usband was
attempting to become chief executive officer ( C EO ) of BankAmerica. The psychiatrist then
purchased BankAmerica stock on the basis of this i n formation. !d. at 27 1 . It is not clear
from the opinion that Sanford Weill's efforts to become CEO were generally con fidential.
See Janet Bush, Psychiatrist who Tra ded on Pa tien t 's A nx ie t ies, THE FINANCIAL TIMES,
May 19, 1 990, at I 3 ( d iscussing psychiatrist's claim that h e was unsure information he
traded on was confidential). According to the SEC complaint, however, Mrs. Weill also told
Willis that her husband's plans for the company included making a significant capita! infu
sion. See S E C v. Willis , Exchange A c t Release No. 1 2 ,754, 1 9 9 1 S E C LEXIS 1 5 2 , at * 2 (.Jan.
202
[Vol. 26: 1 7 9
that this breach supplied the necessary element for insider
trading.9 6
The misappropriation theory raises more questions about the
scope and source of the underlying duty than the classical theory.
At the forefront is the relationship between the wrongful conduct
and securities fraud. As alluded to earlier, the questions about
whether the fraud in an insider trading case is in connection with a
securities transaction are exacerbated when the victim of the mis
appropriation is not a m arket participant. This difficulty is appar
ent in United Sta tes u. Carpenter.97 Foster Winans, a columnist
for the Wa l l Street Journa l, and his tippees were prosecuted for
trading on information that Winans had gathered for use in a
Journa l column, "Heard on the Street," containing stock market
recommendations. 98 The columns in which the information would
appear had been prepared and publication dates set, but the issues
containing the columns had not been published at the time the
defendants traded. 99 The defendants were convicted of insider
trading on the theory that Winans misappropriated property of the
Journal by using information about the upcoming columns as a
basis for trading. 100
Although Winans had clearly violated a Journa l rule prohibiting
prepublication trading by employees, there was no indication that
this violation injured investors . 1 0 1 Nonetheless, the S econd C ircuit
1 4 , 1991 ) .
Subsequent t o Willis's purchase, B a nkAmerica publicly announced that W eill h a d sought
to become CEO and that BankAmerica was not i nterested i n his offer. BankAmerica stock
traded at prices somewhat higher than i n the five weeks preced ing the announcement. Dr.
Willis then sold his stock for a profit of approximately $27 ,476. Willis , 737 F . Supp. at 2 7 1 ;
S E C v . Willis, 777 F. Supp. 1 1 65, 1 1 68-69 (S.D.N.Y. 1 99 1 ) .
9 6 Willis , 737 F . Supp. a t 274-75. D r . Willis pleaded guilty t o the criminal charges against
him and settled a civil injunction action by the SEC by agreeing to d isgorge h is trading
profits and pay a civil penalty. Doctor Guilty in Insider Case, N Y. TIMES, June 29, 1 990, at
0 1 5: SEC v . Willis, Exchange Act Release No. 1 2 ,7 5 4 , 1991 SEC LEXIS 1 5 2 , at *2 (Jan. 1 4 ,
1 99 1 ) ; s e e a lso United States v . W i llis, 7 7 8 F . Supp. 205, 209 ( S . D . N . Y. 1 9 9 1 ) ( refusing t o
dismiss indictment i n light of en bane decision in Ches t ma n ) .
"7 791 F .2d 1024 ( 2d Cir. 1986 ) , aff'd b y a n e q u a lly divided Cou r t , 4 8 4 U.S. 1 9 ( 1 9 8 7 ) .
98 !d. at 1026.
"" !d. at 1 027.
' "" !d. at 1025. The Wall Street Jou rn a l hf.ld a formal policy prohi biting prepu blication
trading and making the contents of upcoming col umns the exclusive p roperty of the .Jo u r
n a l . l d . at 1 026.
'"' A direct injury to investors could b e d emonstrated i f Winans pu blished information
that was false, i n tending to induce investors to trade, and thereby profiting from the market
1991]
INSIDER TRADING
203
affirmed Winans's conviction for insider trading1 0 2 and , in doing so,
failed to adhere to the Blue Chip requirement that, in order for
liability to attach under Rule 10b-5, the defendant's fraud must
result in a securities transaction by the victim . 10 3 Describing the
lower courts ' findings , the Supreme Court explained,
Although the victim of the fraud, the Journal, was not a
buyer or seller of the stocks traded in or otherwise a mar
ket participant, the fraud was nevertheless considered to
be "in connection with" a purchase or sale of securities
within the meaning of the statute and rule. The courts
reasoned that the scheme's sole purpose was to buy and
sell securities at a profit based on advance information of
the column's contents. 1 04
The Supreme Court affirmed W inans's insider trading convic
tions by an equally divided vote. The Supreme Court's opinion is
not explicit, but it i s likely that the four Justices who voted to
reverse in Carpenter were troubled by the issue of whether, under
the misappropriation theory, there is a sufficient connection be
tween the fraud and a purchase or sale of securities. 1 05
effect of t h e false information.
1 02 Carpenter, 79 1 F.2d at 1 033. Winans's conviction for securities fraud was atlirmed by
an equally divided Supreme Court. The Supreme Court unanimously affirmed his ccmvic
tions for wire and mail frauds. Carpenter v. United States, 484 U . S . 1 9 ( 1 987 ) .
1 03
The Second C i rcuit had previously established its position that B l u e Chip did not
require l iability to be based on the breach of a d u ty to a purchaser or seller of securities.
United States v . Newman, 664 F.2d 1 2 , 17 (2d Cir. 1 98 1 ) , cert. denied, 464 U.S. 863 ( 1 983 ) .
T h e district court in Newman dismissed t h e indictment because Newman h a d n o t breached
a d uty to, and thereby defrauded, any seller of securities. !d. at 14. The Second C ircuit
reversed, finding that Rule 10b-5 does not require the defrauding of a buyer or seller of
securities and holding that l i ability could be prem ised on Newman's breach of his duty to
his employer. /d. at 1 7 .
' "' Carpenter, 484 U . S . at 2 4 . T h e Second C ircuit h a d previously used similar reasoning
to find a connection with t h e purchase or sale of securities in its development of the m isap
propriation theory. For example, i n Newman, the court concluded that "since appellee's sole
purpose in participating in the misappropriation of confidential takeover information was to
purchase shares of the target companies, we find l i t tl e merit i n h is d isavowal of a connection
between the fraud and the purchase." 664 F.2d a t 1 8 .
1 05 Inde<:: d , under t h e B l u e Chip doctrine, see supra notes 65-68 and accompanying text,
the Journ a l , the victim of the fraud, would lack standing to bring a private civil claim
against Vv inans for securities fraud because i t was not a purchaser or seller. Barbara B.
A ldave, Th e Misapprop ria t ion Theory: C arpenter and its Aft er m a t h , 4 9 O H I O ST. L..J. 873.
376-77 ( 1 988 ) ; Nicholas Georgakopoulos, Note, Classical and Cross Insider Trc.ding Varia
tions on t h e Th eme of R u le I Ob - 5 , 2 8 AM. B us. L . J 109, 136 ( 1 990 ) . N o r i:. the S e ccmd
.
204
GEOR GIA LA W RE VIE VI
[ Vol. 26: 1 7 9
Although i t may b e wrong t o violate a relationship of trust and
confidence by breaching an employer confidentiality policy, as W i
nans did i n Carpenter,106 o r b y using information obtained in the
course of rendering psychiatric services, as in Wi l lis , 1 07 these
wrongs are not fraudulent or deceptive. It is difficult to understand
how trading on information obtained through such a relationship
defrauds 108 the source of the information or anyone else. 1 09 If Dr.
Willis trades on confidences obtained from his patients or discloses
them at a cocktail party, he has done harm to the trust that his
patients have reposed in him. The disclosure, however, while it vio
lates the psychiatrist-patient privilege, does not constitute fraud .
Unlike the Cady, Ro berts duty to disclose or abstain, the acquirer's
duty to the source under the misappropriation theory is one of
simple nondisclosure . The source is harmed if its confidences are
disclosed, regardless of whether the acquirer subsequently trades,
and the harm is not exacerbated by his trading.
It is important to recall, in this context, that section l O ( b ) is
triggered only by deception. We do not think of the doctrine of
common -law fraud as applicable to a son who makes use of infor
mation received from his father in a relationship of trust and confi
dence, even if by using the information the son is breaching that
trust. 1 10 Once again, we must reconcile the notion of what consti
tutes a fraud under section l O ( b ) with the Supreme C ourt's re
minder that this section was aimed only at fraud, as well as the
C i rcuit's statement regarding the p urpose of the fraud satisfactory. Accordi n g to the court's
reasoning, any theft or fraud would constitute securities fraud as long as the defendant
i ntended to use the proceeds of the crime to p urchase stock. Carpenter, 7 9 1 F . 2d at 1 0 3 1 .
1 0 6 Com mentators have argued that the Journal suffered damage to its reputation. See,
e.g. , Macey, supra note 44, at 43 ( " I f readers thought that the Journal's fi n a ncial news was
tainted by its reporters' quest for personal profit, the paper's influence, and therefore its
readership and advertising revenues, would decl i n e . " ) .
1 07 U ni ted States v. Willis, 737 F . Supp. 269, 275 (S.D.N.Y. 1 990).
1 0 8 In general, in order for the government to obtain a conviction on the basis of fraud, it
must prove that the defendant contemplated some harm or injury to his victim. See, e.g
U n i ted States v . S tarr, 8 1 6 F.2d 94, 9 8 ( 2 d C i r. 1 987) ( reversing mail fraud convic:tions be
cause government fai led to prove that defendants intended to harm customers).
1 0 9 The court in Willis explained that " [b ) y not advising his patient of his i ntention to
disclose her confidential i n formation and to profit personally from it, D r . W i l lis fraudulently
induced his patient to confide i n him i n connection with his purchase and sale o f securities . "
Wi l lis, 7 3 7 F . Supp. at 274.
1 1 0 See supra notes 90-93 and accompanying text (discussing U n i t e d States v . Reed, 601
F . Supp. 685 ( S . D . N. Y . ) reu 'd in part on o t h er grou nds, 77:3 F . 2 d 4 7 7 ( 2d Cir. 1 98 5 ) ) .
. .
19 9 1 ]
INSIDER TRADING
205
c ave at that even Rule lOb-5 does not provide a remedy for all
fraud. 1 1 1
I t i s hard t o see how any breach o f a private duty o f nondisclo
sure can implicate the objectives of the securities laws , which are
concerned with duties to the market. Protection of the securities
markets and innocent investors does not seem to bear any relation
to whether an employee breached a duty of confidentiality to his
emp loyer, or a son to his father . 1 1 2 Is it any different to a third
party trading contemporaneously in the market if W inans traded
with permission of the Jou rna l, if Reed lacked any sort of relation
ship of trust and confidence with his father, or if confidential infor
mation was overheard by a third party who had no duty whatso
ever to the source of the information? 1 1 3
Finally, it i s not clear that expansion o f insider trading under
the misappropriation theory is necessary. There are alternative
ways to address much of the conduct to which the theory has been
applied. One of the thorniest areas in the insider trading debate is
the extent to which the prohibition should cover trading by outsid
ers. In particular, classic outsiders, such as Winans , do not obtain
their information as corporate insiders or tippees. Thus, prosecu
tion of such outsiders requires doctrine to be stretched very thin.
It might be preferable to remove these cases from the insider trad
ing area altogether. After all, Winans was not trading on classic
" inside" information; the information that formed the basis of his
' " S e e supra text accompanying note 68 (discussing B l u e Chip d ecision ) .
112
I n United States v. Newman, t h e Second C i r c u i t expressly cautioned t h a t t h e indict
ment was based on a breach by the defendants of a duty to their employer and the em
p loyer's cli ents, not on a duty to the marketplace or to the shareholders of the target com
panies. 664 F.2d 1 2 , 15 n . 1 (2d Cir. 1 98 1 ) , cert. denied, 464 U.S. 863 ( 1 983 ) . The Second
C ircuit subsequently explained, in Moss v. Morgan Stanley Inc., that the breach of a duty to
the source under the misappropriation theory cannot b e " stretched to encompass an em
p loyee's 'duty of d isclosure' to the general public." 7 19 F.2d 5 , 1 3 (2d Cir. 1 983), cert. de
nied, 465 U.S. 1 025 ( 1 984 ) . But see Norman S . Poser, Misuse of Confide n t i a l Information
Concerning a Tender Offer as Securities Frau d , 49 B ROOK L. REv. 1 265, 1 270 ( 1 983) ("Re
gardless of how the defendant received the i n formation . . . public i nvestors are equally i n
need of protection . " ) .
113
An exampl e of this last scenario is provided by SEC v. Switzer, 590 F. Supp. 756, 766
( W . D . Okla. 1984), i n which the SEC attempted to prosecute a football coach who traded
based on d iscussions he overheard while in the stands at a game. The court rejected the
SEC's argument since Switzer was not i n a fiduciary position and did not know the informa
tion on which he traded was the result of an insider breach. !d.
206
GEOR GIA LA W R E VIE W
[Vol. 26: 1 79
columns was all in the public domain . 1 14
Winans conceivably might have been prosecuted for " scalping,"
a legal theory that does not depend on an insider trading analy
sis. 1 1 5 Scalping is trading by an investment advisor for his own ac
count based on the market effect of his recommendations to inves
tors . 1 1 6 Although scalping is p rohibited by the Investment Advisors
Act of 1940,1 17 these prohibitions probably do not apply to newspa
per reporters. 1 18 Alternatively, prepublication trading may be
viewed as traditional securities fraud. 1 1 9 One might treat a colum
nist's recommendations as a representation to the public, upon
which the column's readers rely in purchasing and selling securi
ties. Clearly, when a financial columnist publishes a column of
stock recommendations, he intends to convey information to the
financial marketplace and expects readers to make trading deci
sions in reliance on those recommendations. The columnist who
makes prepublication trades in order to benefit from the publica
tion effect of his column has a conflict of interest. 120 The purchases
' ' ' S e e Brudney , supra note 1 3 , a t 368- 7 1 ( d iscussing liability for trad i n g o n i n formation
within public domain).
" ' S e e SEC v. Capital Gains Research B ureau, Inc. , 375 U . S . 1 80 , 181 ( 1 963) (holding
scalping to be fraud or deceit upon client or prospective client).
" " !d. at 1 96. Although a n i nvestment advisor may readily anticipate the market effect of
a good faith recommendation, the danger i n scalping is that an advisor will recommend a
given security not because of i ts potential for a long-term price i ncrease but because of its
potential for a short-term price reaction to the advisor's recommendation.
117
15 U.S.C. §§ 80b - 1 to 80b - 2 1 ( 1 988).
" " The definition of investment advisor under the 1 940 Act explicitly excludes " th e pub
l isher of any bona fide n e wspaper, n ews m agazine or business or fi nancial p ublication of
general and regular circulation." 15 U.S.C. § 80b-2 ( a) ( l l ) ( 1 988) . The statute does not ad
dress the status of reporters or employees of a publisher. See Cox, supra note 5, a t 385
( p lacing Winans and the Journal beyond reach of I n vestm e n t Advisors Act) .
119
See, e.g. , Zweig v. H e arst Corp. , 594 F.2d 1 2 6 1 , 1 2 7 1 ( 9th Cir. 1 97 9 ) . I n Zweig, the
court found that a newspaper columnist who made a practice of engaging i n p r e pu blication
trading could be civilly liable under Rule 10b-5 for failing to d isclose the conflict o f i nterest
i nherent in his trading. See a lso SEC v. C ampbell, [ 1 972- 1 97 3 Transfer B i nder] Fed. Sec. L .
R e p . ( C C H ) 11 93,580, at 92,703 ( C . D . Cal. 1972) ( reporting prosecution of i n vestment colum
n ist under Rule 10b-5 for prepubli cation trading) .
120
As the Ninth C ircuit stated in Zweig, " [R ] easonable i nvestors who read the colu m n
would have considered t h e motivations of a fi n a ncial columnist such as Campbell i mportant
i n deciding whether to invest i n the companies touted." Zweig, 594 F.2d a t 1 266; see Cha
sins v . Smith, B arney & Co., 438 F.2d 1 167, 1 172 ( 2d Cir. 1 970) (requiring broker/dealer to
d isclose fact that i t was a market maker i n recommended stock); see a is o B rudney, supra
n ote 1 3 , at 369 (arguing that columnist makes implied warranty of disinterestedn ess, which
i s breached by scalping); Cox, supra note 5, at 385 (arguing that client is a ided i n assessing
strength of analyst's recommendation by knowledge that analyst "is serving two masters,
1 991 ]
INSIDER TRADING
207
will increase in value, based on the columnists favorable recom
mendation, whether or not the stock is actually worth more than
the current market price. Thus, it seems that Winans could be
prosecuted for failure to disclose his own trading to the paper's
re aders /2 1 who are then defrauded in connection with their subse
quent sale or purchase in relia:qce on the column. 1 22
Similarly, misappropriation theory covers a range of wrongful
conduct that can be addressed with standard criminal laws / 2 3 such
as theft and mail fraud. 124 The burglar who breaks into an office in
order to obtain confidential corporate information for trading is
stealing as well as engaging in insider trading. 125 Moreover, the
theft of corporate information through less dramatic means may
qualify as conversion or embezzlement. 126
Many of the proposed definitions of insider trading would only
exacerbate this problem. With their emphasis on the wrongful ac
quisition of inside inform ation, the proposals would increase the
one o f which is his own self- i nterest").
11 1
One commentator suggests that the alternative is to have the newspaper publish a
statement disclosing that employees are permitted to engage in prepublication trading. Mar
tin Kimel, Note, The Inadequa cy of R u le l Ob-5 to Address Ou tsider Trading by Reporters,
38 STAN. L. REv. 1549, 1 5 7 1 ( 1986 ) .
1 22
The theories whereby scholars claim Winans's scheme damaged the reputation of the
Journ a l are based o n the belief that the Jou rnal's readers will perceive the content o f the
columns as tainted by Winans's personal p rofit motive and accord them less reliability. See
supra note 1 06.
123
M isappropriation theory has also been criticized on the basis that it duplicates state
agency law. Georgakopoulos, s upra note 105, at 137 n.93.
1 24
In Chiarella , Chief Justice B urger q uoted with approval a passage from a 1 936 law
review article that stated , " [a ] ny time information is acquired by an i l l egal act it would
seem that there should be a duty to disclose that i n formation. " C hiarella v . U nited States,
445 U.S. 222, 240 ( 1 980) ( B urger, C.J., dissenting) (quoting W . Page Keeton,
Fra u d � Concealment and Non-Disclos u re , 15 TEx. L. REv. 1, 25-26 ( 1936 ) ) . The mere fact
that the acquisition has taken place through an illegal act suggests, however, that an alter
native mechanism exists for redressing the wrong. See U nited States v. Carpenter, 791 F.2d
1024, 1036-37 (2d Cir. 1 986) ( M iner, J., d issenting i n part) ( arguing that broadening federal
securities laws to cover Winans's conduct is unnecessary because conduct could be c:de
quately addressed by mail and wire fraud statutes) , aff'd, 484 U.S. 19 ( 1 987 ) .
' 2 5 See, e.g. , S E C v . Cherif, 933 F . 2d 403, 4 1 7 ( 7 t h Cir. 1 99 1 ) (convicting under m isappro
priation theory terminated bank employee who gained access to bank after d ischarge) , cert.
denied, No. 9 1 -605, 1 992 U.S. LEXIS 658 (U.S. Jan. 27, 1 992). See genera lly Gary Lawson,
The Ethics of Insider Trading, 1 1 H ARV. J.L. & PuB. PoL'Y 727, 767 ( 1 988) (stati ng that it is
unclear why state criminal law is n ot adequate for insider trad ing that is equivalent of
theft ) .
' 2 " See, e.g. , Macey, supra n ote 4 4 , at 28-29 (arguing that Chiarella's u s e of tender offer
information for his personal trad ing was breach of contract and theft ) .
208
[Vol. 26: 1 7 9
duplication between insider trading and current criminal statutes.
For example, the SEC's proposed insider trading bill would pro
hibit the use of, among other things, information that has been
obtained by or as a result of " theft, bribery, misappropriation or
espionage. " 1 27 The proposed Insider Trading Proscriptions Act of
1 9 87128 would prohibit the use of information obtained by " theft,
conversion, [or] misappropriation. " 1 29
II.
APPLICATI ONS OF C URRENT IN SIDER TRADI N G LAW
Notwithstanding the logical flaws , many commentators accept
the judicially developed theories of insider trading, based on a fun
damental perception that insider trading is unfair a n d wrong. 1 30
Given this perception, one might conclude that those who engage
in such trading should be held liable in spite of the diffi culties in
articulating the rationale for such liability. Even with this ap
proach, however, the problems associated with insider trading reg
ulation are evident. The viability of a theory of liability does not
depend only on whether liability is reasonable but also o n whether
it can be imposed in a logical manner.
A.
LIABILITY FOR TIPPING
One fundamental difficulty is determining how to impose liabil
ity for tipping. Who, if anyone , should be prosecuted when an in
sider, rather than trading himself, tips the information to others
who trade in reliance on that information? Under both the classi
cal and the misappropriation theories o f insider trading liability,
the original acquirer of the information and anyone who receives
the information from that acquirer may be held liable for insider
trading . Indeed, in Cady, Ro bert s , the defendant who traded on
the basis of inside information was not a corporate insider but the
1 2 7 Securities and Exchange Commission Proposed I nsider Trading B i l l ( Nov. 1 8 , 1 98 7 )
[ hereinafter SEC Modified Proposal ] , repri n t e d i n SEC Compro m is e Prop o s a l o n Insider
Tra ding Legis l a t i o n ; Accompa nying L e t t e r, and A n a lysis by A d Hoc Legis l a t ion Com m i t
Sec. Reg. & L . R e p . ( B N A ) No. 4 7 , at 1 8 1 7 ( Nov. 2 7 , 1 9 8 7 ) . T h e b i l l is also reprinted
in Symposium, D e fi n i ng "Insider Tra ding ", 39 ALA. L. REv 531 app. ( 1 988 ) .
128
S . 1 3 80, lOOth Cong., l s t Sess. ( 1 987 ) , repri n t e d i n Symposium, s u p ra n o t e 1 2 7 , at 53.5
app.
1 2"
!d. § 3 : s e c K im e l , supra note 1 2 1 , at 1 564 ("Federal securities laws are n o t needed t o
protect employers from theft. " ) .
"'0 E.g , B rudney, s u p ra note 1:3 , at 3.54 - 5 5 ; B a i nbridge, s u pra n o t e 2 2 , a t .J .J - (3 2 .
tee, 19
1 99 1 ]
INSIDER TRADING
209
partner of a director. The Commission failed to explain how the
tippee inherited his p artner's fiduciary duty; it simply based liabil
ity on the fact that the broker knew the information was nonpublic
and had been received from an insider. 1 3 1
The courts appear t o predicate the liability o f a tippee o n the
tipp er's breach of some duty. As the C ourt in Chiare l la explained,
" [t] he tippee's obligation [ not to profit from the inside informa
tion] has been viewed as arising from his role as a p articipant after
the fact in the insider's breach of a fiduciary duty. " 1 32 Thus, it is
necessary for the tipper to act wrongfully in order for his tippee to
incur liability. The extent of this requirement was clarified in
Dirks u. SEC, 133 in which the Supreme Court found that Secrist,
the corporate insider and source of the information/ 34 had com
mitted no breach of fiduciary duty in disclosing the information to
a securities analyst, Dirks. 1 35 Accordingly, Dirks could not have
been a participant after the fact in a breach of fiduciary duty and
hence could have no derivative liability as a tippee . 1 36
The SEC has taken the position that a tippee stands in the shoes
of the tipper, inheriting the tipper's fiduciary duty. If the tipper
would be barred from trading by virtue of his insider position, the
tippee is similarly barred. 137 The Court in Dirks , however, rejected
this position . 1 38 The C ourt held that, before a court imposes liabil
ity upon a tippee, the government must satisfy a two- part test. In
addition to proving a primary breach of fiduciary duty by the tip1 3 1 In re
Cady, Roberts & Co., 40 S . E . C . 907, 9 1 2 - 1 3 n . 17 ( 1 96 1 ) .
Chiarella v . U n i ted States, 445 U . S . 222, 230 n . 1 2 ( 1 980) .
1 33 463 U.S. 646 ( 1983).
"' Secrist, a former officer of Equity Funding of America (EF A), disclosed to Dirks, a
securities analyst, that a major fraud was being perpetrated at EFA. Secrist " u rged D irks to
verify the fraud and d isclose it publicly." !d. at 649.
1 36
ld. at 666. The Court's m e thod of determining whether Secrist breached a fiduciary
duty in revealing the fraud to D irks may have been overly simpl istic. The Court concluded
that the test for whether a n i nsider acted improperly in revealing inside i n formation was
" w hether the i nsider personally w i l l benefit, directly or i ndirectly, from his disclosure. " ld.
at 662. Thus, an i nsider breaches h is duty i n revealing i nside information only i f he receives
a personal benefit from the d isclosure, such as a pecuniary gain or a benefit to his reputa
tion that will translate i n to future earnings. !d. S ince Secrist received no money or personal
benefit, the Court held h e had breached no duty to EFA. !d. at 662.
1 36
!d. at 667 . The Court concluded that t ippees do not inherit the i nsider's duty to dis
close or abstain merely because they receive i nside i n formation; tipees only i nherit the in
sider's duty i f the i n formation " has been made ava i lable to them imp.-operly . " !d. at 660.
1 3 7 !d. at 655.
13" !d. at 655-59.
1 32
210
[ Vol. 26: 1 7 9
per, the government must show that the tippee knew o r h a d reason
to know that the information was nonpublic and had been wrong
fully obtained . 1 39
Neither requirement fills the void in the Cady, Roberts opinion.
The Court in Dirks still did not explain how a tippee who does not
obtain (or pass on) inside information-in breach of a fiduciary
duty to the stockholders, the source of the information, or someone
else-can commit securities fraud by trading on the basis of that
information. How can such trading be a fraudulent omission if the
tippee has no duty to speak? 140 Agency principles do not supply an
answer. Even if the original insider had a fiduciary duty to his
shareholders, the tippee does not inherit that same d uty upon re
ceiving a tip. Moreover, if the insider tips in breach of a duty of
nondisclosure, it is illogical to find that this duty of nondisc losure
is converted , in the hands of the tippee, into a duty to dis c lose.
The problem is further complicated by the willingness of Con
gress 1 4 1 and the courts to impose insider trading liability upon an
insider who tips but does not trade. 1 42 Such liability is really sec
ondary in nature; the insider is aiding and abetting the violation
committed by the tippee's trading. But if the insider abstains from
trading, he is not violating the Cady, Ro berts duty. Moreover, un
less disclosure of the inside information harms the company (or
1 ""
1 10
! d . at 6 6 1 -64.
It has been suggested that a tippee " in h erits" the duty from the tipper as long as the
tippee knew or should have known that the i n formation was improperly obta in e d . SEC v .
M usella, 578 F. Supp. 425, 439 (S.D.N.Y. 1 9 8 4 ) ; see Phill ips & Zutz, supra note 5, at 89
( terming this the " ' inheritance' theory . " ) ; cf. D irk s , 463 U . S . at 655-56 ( rejecting notion
that tippee i nherits Cady, Roberts duty absent breach of that duty by tipper).
14 1
The Insider Trading Sanctions Act of 1 984, § 2, 1 5 U .S . C . § 78u ( d ) ( 2 ) ( 1988) , provides
for the imposition of civil penalties o n nontrading tippers based on the belief that " [ a ] bsent
the tipper's misconduct. the tippee's trading would not occur." H . R. REP. No. 355, 98th
Cong., 1 st Sess. 9, reprin ted in 1 983 U . S . C . C.A.N. 2274, 2282.
1 '" See, e.g. , Shapiro v . Merrill Lynch, P ierce, Fenner & Smith, Inc., 495 F.2d 228, 241 (2d
Cir. 1 974) ( holding stockbroker l iable for tipping institutional clients based on i n formation
M errill Lynch received as result of p erforming u nderwriting work ) ; see a lso S E C v. Texas
Gulf Sulphur C o . , 401 F . 2 d 833, 848 (2d Cir. 1 968) (describing duty of insider who possesses
material nonpublic i n formation to " abstain from trading i n or recommending the securities
concerned while such inside i n formation remains u n disclosed") ( emphasis added ) , cert. de
n ied, 394 U.S. 976 ( 1 969 ) . Indeed, Dirks d i d not himself trade i n the stock of E q uity Fund
i ng. Dirks, 463 U.S. at 665. T hese cases can be addressed , as the D istrict o f Columbia Cir
cuit did in Dirks, by finding that securities professionals, by virtue of their position, have a
fiduciary duty to the marketplace not to e ngage in selective d isclosure. D i r ks v. SEC, 681
F.2d 824, 840 ( D . C . C i r. 1982), reu'd, 463 U.S. 646 ( 1 983 ) ; s e e infra note 265.
1 99 1 ]
INSIDER TRADING
211
res ults i n personal gain t o the insider ) , it is difficult to find a
brea ch of fiduciary duty, even when the disclosure is selective . 143
Thus, the courts impose liability for a tipper's breach of a duty of
nondisclosure alone. But this breach is no more deceptive if a tip
pee purchases securities based on the information disclosed than if
the tippee sells the information to a competitor or otherwise uses
the information to his business advantage. This contradiction is
the result of focusing on the tipper's fiduciary obligations to assess
whether the insider trading prohibitions have been violated.
Whether the tippee trades is irrelevant. Nevertheless, the SEC
does not appear to have taken the position that disclosure by cor
porate insiders of inside information is, by itself, insider trading or
securities fraud, as long as no subsequent recipient of the informa
tion trades securities in reliance on the information.
B.
CHO O S IN G BETWEEN CLASSICAL THE ORY AND MISAPPROPRIATION
A major difficulty in applying the existing insider trading theo
ries is choosing which theory to use. Courts have not always distin
guished clearly between the two theories144 in reviewing insider
trading convictions. 1 411 Nor is it always intuitively obvious which
theory is appropriate . For example, professionals such as invest
ment bankers and lawyers are frequent targets in insider trading
prosecutions based on their misuse of information conveyed to
them for professional purposes. Such traders can be prosecuted
" 3 An example is a recently settled action by the SEC against Phillip Stevens, the former
CEO of U ltrasystems Corp . , SEC v. Stevens, 91 Civ. 1 869 ( C S H ) ( S . D . N . Y . Mar. 1 9 , 1 9 9 1 ) .
See Ex- CEO Sett les Charges H e Disclosed A dverse Inside Information t o A n a lysts, 23 Sec.
Reg. & L. Rep. (BNA) No. 12, at 439 ( M ar. 22, 1 99 1 ) [herein a fter Ex- C E O ] . Stevens alleg
edly conveyed nonpublic i n formation to securities analysts that Ultrasystems would have
lower earnings than expected. The SEC claimed that Stevens tipped in order to i mprove
"his status as a corporate manager . " Id. A pparently Stevens believed tipping would enhance
his cred ibility among analysts and enable h i m to function as a more effective CEO. Thus,
S tevens's tips can be viewed as attempts to help the issuer rather than as a breach of his
fiduciary duties.
1 44 Some commentators believe that derivative or tippee liability should b e treated as a
d istinct category of i nsider trading regulation. E.g. , LANGEVOORT, supra note 2, at 1 0 1 -39.
This belief is based, i n part, on the fact that derivative liability brings additional analytical
problems to the i nsider trad i ng debate. See id. at 363-94 ( noting gray areas of i nsider trad
ing liability ) .
' " When used t o refer t o insider trading l itigation, t h e term " couviction" should b e read
broadly to include cases in which the government has been successful in a civil enforcement
a ction or admi nistrative proceeding as well as a criminal prosecution.
212
[ Vol. 26 : 1 79
under the classical theory based on the view that they became tem
porary insiders when they received information for a corporate
purpose. 145 Alternatively, under the misappropriation theory, the
traders may be prosecuted as outsiders who have m isappropriated
the information through the process of converting it to their per
sonal use. Professionals also may be viewed as tippees, although,
after Dirks, such a predicate for liability appears dubious because
corporate officers do not breach a fiduciary duty in communicating
information to professionals for business purposes.
The problem is illustrated by the recent prosecution of Robert
Chestman. 1 47 Chestman, a broker, was prosecuted under the mis
appropriation theory for trading on information about a forthcom
ing tender offer for the stock of Waldbaum, Inc. C hestman ob
tained the information from Keith Loeb, a nephew by marriage of
a Waldbaum insider. 148 Loeb had no inside position in the com
pany, and he disclosed the information to Chestman voluntarily;
between Loeb and Chestman there was no theft or breach of confi1 16
The Court stated in Dirks:
Under certain circumstances, such as where corporate information i s revealed
legitimately to an underwriter, accountant, lawyer or consultant working for
the corporation, these outsiders m ay become fiduci aries of the shareholders.
The basis for recognizing this fi duciary duty is not simply that such p e rsons
acquired nonpublic corporate i n formation, but rather that they have e n tered
into a special confidential relationship i n the conduct of the business o f the
enterprise and are given access to i n formation solely for corporate p u r poses.
D i r k s v . SEC, 463 U.S. 646, 655 n . 14 ( 1983 ) .
When such a person breaches h is fi d uciary relationshi p , h e may be treated m o r e properly
as a tipper than as a tippee. Thus, for exam p l e , in SEC v. Musella, 578 F . S u p p . 425, 441
( S . D . N . Y . 1 984), i n which the office manager of a law firm disclosed i nform ation about the
merger and acquisition plans of the firm's clients, l iability m ight more appropri ately have
been based on the treatment of the d e fendant as a constructive insider. Instead, the court
d e termined that the defendant had, i n tipping, m isappropriated the i n formation. I d . a t 43839.
1 1 7 United S tates v . C hestman, 903 F.2d 75, 82, 84 ( 2d Cir. 1 990) , v a c a t e d in part on
reh 'g, 947 F.2d 551 (2d Cir. 1 9 9 1 ) (en bane) . The court's decision en bane reversed
C hest man's conviction for insider trading under Rule lOb-5 but upheld his conviction under
Rule 1 4e-:3, see i nfra note 1 50.
1 18
The government's theory of the case was that C hestman had received inside i n forma
tion about Waldbaum stock from Loeb. !d. at 75. Chestman maintained that his trading was
motivated by his independent analysis of Waldbaum stock. Chestman claimed that h e d i d
not d i scuss Waldbaum stock w i t h L o e b p r i o r to m a k i n g the purchases f o r which he was
p:·l•secuted. !d. at 555. C hestman's testimony at trial was cmroborated by t h a t of his admin
istrati·,·e assistant, who testi.fied that as of late morning or early afternoon of the day
C hestman purchased Waldbaum stock, Chestman had not spoken to Loeb. F l um enbaum &
l'� a r p , suprn note 8, at 3.
1991 ]
INSIDER TRADING
213
dence. Thus, Chestman could b e prosecuted only a s a tippee and,
at that, only as a remote tippee. 1 49
The panel of the Second Circuit that heard Ches tman came to
three separate conclusions with respect to Chestman 's conviction
under Rule 14e-3150 but unanimously reversed Chestman 's convic
tion under Rule l Ob - 5 . 1 5 1 Upon rehearing en bane, a sharply di
vided Second C ircuit agreed with the panel and reversed the con
viction under Rule lOb-5.152 The court held that prosecution under
the misappropriation theory, under which C hestman was
charged ,u':3 required proof that C hestman knew Loeb was breach
ing a relationship of trust and confidence, that is, misappropriating
information. 1 54 The evidence with respect to Loeb's misappropria
tion was shaky at best-the information had been passed down a
chain of fami ly members, in each case upon a pledge of secrecy
that was broken. 1 55 Loeb received the information from his wife,
who was not a Waldbaum insider, who had no fiduciary duties to
the co�pany, and who was expressly authorized to disclose the in-
' '" Ch est m a n , 9 4 7 F . 2 d at 570- 7 1 ; s e e Coffee, supra note 9 3 , at 5 (''Put simply C hestman
was a fourth-level tippee . " ) .
"" S EC Rule 1 4 e - 3 , 1 7 C . F . R. § 240. 1 4e - 3 ( 199 1 ) , regulates trading whenever a bidder has
either taken substantial steps to commence or has commenced a tender offer. Absent public
disclosure, the rule prohibits trading by anyone who is i n possession of m aterial nonpublic
information concerning the offer and who knows or has reason to know that the information
came from the bidder or the target com pany, d i rectly or indi rectly. The bidder is exempted
from this prohi bition.
The Second Circuit panel reversed C hestman's conviction under Rule 14e-3 by a two-to
one vote. Judge M ahoney felt that Rule 14e-3 was an invalid exercise of the S EC's rulemak
ing power. Ches t m a n , 903 F.2d a t 84 ( M a honey, J., concurring in part and dissenting in
part) Judge Carman determined that Rule 14e-3 required proof of fraudulent acts and de
termined that, because the trial court did not instruct the j ury on the elements of fraud,
Chestman's conviction must be reversed. !d. a t 86 (Carman, J . , concurring i n part) . The e n
b a n e court, however, d isagreed w i t h t h e panel and concluded both that R u l e 14e-3 was a n
appropriate exercise of the SEC's rulemaking power and that C hestrnan ' s convict ion under
the rule was proper. Ches t m a n , 947 F.2d at 556-64. The validity of Rule 14e-3 obviously
implicates a number of the issues discussed herein, but a comprehensive treatment of the
rule is beyond the scope of this Article.
1 5 1 Ches t m a n , 903 F.2d at 80, 84, 86.
'" 947 F.2d 551 (2d C ir. 199 1 ) (en bane ) . Five j udges dissented from the reversal of
C hestma n 's convictions under 10b-5. !d. at 57 1 .
' ·' " C hestman was convi cted o f both aiding a n d abetting insider trading b y assisting
Loeb's purchase of stock and of trading as a tippee with respect to purchases on behalf of
h i mself and others. Chest m a n , 947 F.2d at 564.
.
•
"' ' / d .
," See Ches t m a n ,
part l .
903 F.2d at 77; Ches t m a n , 947 F.2d at 579 ( \Vinter, , J . , dissenting in
214
[Vol. 26: 1 7 9
formation to her husband. 1 56 Moreover, there was n o evidence that
Loeb ever agreed to keep the information confidential. 111 7 Under
those circumstances, the court found it impossible to conclude that
Loeb had breached a duty in disclosing the information to
Chestman . 1 58 If there was no breach of duty, then C hestman, not
withstanding the fact that his conduct suggested consciousness of
guilt, 1 5 9 could not have knowledge of such a breach.
At oral argument before the en bane court, the prosecution tried
to base a duty on the family relationships involved, i n p articular
on the marital relationship between Keith and Susan Loeb . The
prosecution argued that the marital relationship was persuasive, if
not conclusive , evidence of a relationship of trust and confi
dence. 1 60 From this relationship , the government tried to infer a
duty to hold interspousal communications confidential. 1 6 1 The dif
ficulties with this approach are apparent. It would be difficult
enough for the family member involved, much less his tippee, to
evaluate every conversation with a relative and to distinguish relia
bly confidential conversations from ordinary family gossip . 1 62
Of course, the government was not required to prosecute
C hestman under the misappropriation theory. Intuitively, the
classical theory of insider trading seems better suited to the facts
of the Chestman case. Ira Waldbaum, the original source of the
confidential information, was a traditional insider. 1 63 The informa
tion was passed from Waldbaum to Chestman through a series of
Waldbaum family members.164 Why is this not a classic case of re
mote tippee liability? One answer is that the case illustrates the
above-described logical difficulties with derivative liability for tip1 06
1 07
Chestman, 9 4 7 F.2d at 5 7 9 ( Winter, J . , dissenting i n part ) .
!d. at 57 1 .
" s I d.
1 06
!d. This conduct included his denial that h e had ever d iscussed the W aldbaum stock
with Loeb. See id. at 555-56.
160
In his opinion, dissenting on the reversal of C hestman's convictions under Rule lOb-5,
J udge W inter attempted to articulate a test for recog n izing a fiduciary duty b ased on a
familial relationship. !d. at 579-80 ( W i nter, J . , dissenting in part ) .
161
!d. The Chestman indictment c h arged that Loeb had breached a d uty o f trust and
confidence to his wife and her family when h e tipped C hestman. Chestman allegedly aided
and abetted this breach by trading. C offee, supra note 93, at 5.
162
See C h e s t m a n , 947 F.2d at 582 - 83 ( M iner, J . , concurring) ( criticizing " familial rela
tionship" rule as difficult to apply and i n h i biting family discourse ) .
16"
I d. at 555.
1 6·1
Jd .
j
l
·l
!
1991]
INSIDER TRADING
215
p ees. 1615 Ira Waldbaum disclosed the information t o Shirley Witkin ,
his sister, for valid business p ur p oses-Witkin had to assemble her
stock certificates in order to effect the u p coming sale of the busi
ness. 166 Since Waldbaum 's disclosure of the sale was for valid busi
ness p ur p oses and not for im p ro p er p ersonal gain, it was not a
breach of any fiduciary duty. Under the reasoning of Dirks, if
Waldbaum breached no duty in disclosing the information, Witkin
could not be liable as a ti pp ee for subsequent disclosure or
trading.167
Accordingly, any culp able conduct in this case is limited to the
disclosure of the transaction by Loeb to Chestman and the subse
quent trading by Loeb and Chestman. B ut this conclusion brings
us back to the question asked by the Ches tman court: why was the
information confidential in the hands of Loeb? Is the sanctity of
the marital relationshi p really the basis for the jury's determina
tion that Chestman's conduct constituted insider trading? Should
insider trading p rosecutions be a tool to enforce the maintenance
of s p ousal confidences? If the concern of the securities laws is the
p rotection of investors through com plete disclosure of investment
information, why should Chestman 's liability for insider trading be
de p endent u p on whether the Loebs' marriage constituted a rela
tionshi p of trust and confidence? 168
1"' Professor Langevoort notes that tippee-derivative liability, especially based on tips to
friends or relatives, constitutes one of the "gray areas" in insider tradi n g regulation.
LANGEVOORT, supra note 2 , at 389-94.
166
Ches t m a n , 947 F.2d at 555.
1 67
I t can be argued that Witkin, too, was a n i nsider, s ince s h e owned Waldbaum's stock
and was a party to the sale that Ira Waldbaum had negotiated. Assuming that Witkin was
an i nsider, one m ust analyze her disclosure to determine i f i t was an i mproper tip. Witkin
was Susan Loeb's mother, and when Susan Loeb became anxious that her mother's activities
reflected a problem with her health, Witkin d isclosed the upcomi ng sale to ease her daugh
ter's anxiety. Ches t m a n , 903 F.2d at 77. Witkin did not d isclose the sale for personal gain or
to make her daughter a g i ft, so, under Dirks, Witkin's d isclosure was not a breach of any
i nsider's duty. Chestman, 947 F.2d at 579 ( Winter, J . , dissenting in part). Moreover, Witkin
told Susan Loeb she could tell her husband about the sale, so when S usan d isclosed the
transaction to Keith she breached neither a duty as a tippee nor a relationship of trust and
con fidence. !d. at 555.
1 68
The Third C ircuit's opinion i n Rothberg v. Rosenbloom, 7 7 1 F.2d 8 1 8 ( 3d Cir. 1985),
provides an equally compelling i llustration of the problem of identifying the appropriate
theory upon which to predicate i nsider tradi ng liability. Defendant Rosenbloom was an i n
sider of Nytronics, a corporation engaged in an attempt to take over Culton I n d ustries.
Rosenbloom tipped Rothberg as to both Nytronics's intention to take over C ulton and his
expectancy that the attempt would be successful, based on Nytronics's favorable contacts on
l
l
216
[Vol. 2 6 : 1 79
j
'1
j
C.
LIMITATIONS OF BOTH THEORIES
The Ches t man case is not the only difficult factual s ituation
under current lines of insider trading analysis. Consider the situa
tion of a business acting as a maj or supplier to a corporation. The
supplier is advised by the corporation's executives that the corpo
ration has significant expansion plans, as yet unannounced, and ac
cordingly will be substantially increasing its orders with the sup
plier. If the supplier trades on that information, has i t engaged in
insider trading? 1 69 The supplier is, in a sense, a tippee, but the
information was communicated to the insider for business pur
poses rather than securities trading. Arguably the supplier m ay be
viewed as a temporary insider when it receives the tip , but it is
unlikely that a supplier that only receives payment fro m the corpo
ration for material provided can be viewed as owing a fiduciary
duty to the corporation and its shareholders . 1 70 Nor can the sup
plier be considered to have misappropriated the information, even
if the executives describe the corporation's plans as confidentiaU71
t h e Gulton board. !d. at 8 2 1 -22.
The Third C ircuit concluded that Rosenbloom's tip violated insider trading law under the
m isappropriation theory because Rosenbloom "owed [ Nytronics] a duty not to d isclose se
cret i n formation which would cause others to buy Gulton stock, thereby making i t more
difficult for Nytronics to consummate a merger on favorable terms . " !d. a t 822. I n his con
curring opinion, Judge H igginbotham agreed with the majority's conclusion but found i ts
reliance on the m isappropriation theory to be misplaced. According to Judge H igginbotham,
the significance of the tip was based on the disclosure of the Gulton board 's likely receptive
ness to the offer, i n formation that came not from Nytronics, the acquirer, but as a leak from
G ulton, the target. !d. at 825 ( H igginbotham, J., concurring) . Even under a fraud-on-the
source theory, Rosen bloom d i d n o t owe a fiduciary duty to Gulton as source o f the i n forma
tion. Judge H igginbotham concluded that Rosenbloom should instead b e fou n d to h ave vio
lated i nsider trading law under the classical doctrine based on the fact that Dr. G ulton, the
G ulton insider who had contact with Rosenbloom, breached a fiduciary d uty under the
Dirks analysis i n leaking the i n formation. Id. (Higginbotham, J . , concurring) .
1 69
Professor Brudney would argue that the supplier has access to an i n formational ad
vantage that is not available to the general p ublic and hence should b e barred from trading.
See B rudney, supra note 1 3 , a t 359 ( arguing that supplier/customer s ituation i n vokes dis
close-or-refrain rule) .
170
I d. at 359 ( [ N ] o legal doctrine seals a supplier's knowledge of a significant i ncrease in
orders by a customer. " ) .
171
O n e commentator refers to situations i n w h i c h insidErs, b y virtue of their position,
receive knowledge about other corporations, to which they owe no fiduciary d uty, as " cross
trading. " G eorgakopou!os, supra note 105, pass i m . The author suggests that, although cross
trading is not classical i nsider trading, it can be reached under the m isappropriation theory.
Further, according to the author, i t s hould b e reached because the policy considerations for
banning cross- trading are even stronger than those underlying the general regulation of in"
I
1 991 ]
INSIDER TRADING
217
The corporation cannot unilaterally impose restrictions o n infor
mati on the supplier has legitimately obtained. 172
Those who argue that trading by the supplier in this case does
not present the same dangers of manipulation of corporate events
and harm to the corporation as trading by insiders may consider
the converse factual scenario, in which the supplier decides to cut
off the supply of material to the corporation and , in anticipation of
that decision, sells the corporation's stock short.173 Should insider
trading regulation be expanded to cover someone who acts in
breach of a contractual duty to the corporation , such as that im
posed by a supply contract, and trades " in connection with" that
breach? 1 74
Finally, consider a corporation that deems itself a possible take
over target. Management, fearing a hostile takeover attempt, ap
proaches other companies as prospective white knights, seeking to
enter into :1 merger on friendly terms . m; Although the disclosure of
sider trading. Id. at 1 33 .
1 72
T h e corporation could, w i t h t h e consent o f t h e supplier, restrict t h e supplier's right to
use the i nformation by contract. This possibi lity raises the question of whether the sup
plier's breach of that contract could b e bootstrapped into an insider trading violation like
that i n the Carpenter case.
173 Professors Carlton and Fischel d escribe the situation of a short seller as providing the
same moral hazard as that of an insider. D ennis W. Carlton & Daniel R . F ischel, The Regu
lation of Insider Trading, 35 STAN. L. REv. 857, 874 ( 1983) .
1 7 4 Professors Carlton and Fischel suggest that there i s n o real possibility o f i nsider trad
ing prosecution i n this situation. !d. The supplier, however , m ight logically be indicted
under the m isappropriation theory, based on the claim that he had a contractual duty not to
use information derived from his business relationship for his personal gain, or under the
classical theory, based on the argument that h e has become a temporary insider of the sup
plied firm. See infra note 175 ( discussing situations i n volving temporary insiders ) .
1 7 6 This factual scenario is similar to those i n a n umber o f reported cases. For example, in
SEC v. Ingram, [ 1 987-88 Transfer B i nder] Fed. Sec. L . Rep. (CCH) 11 93,788, a t 98,720 (C.D.
Cal. 1 988) , Ingram, a securities analyst, wa�' asked by the corporation to look for a merger
partner. I ngram, who was not compensated for his services. located a partner and sat in on
the merger negotiations. During the course of the negot iations, he tipped several of his bro
kerage clients about the deal. The court h e ld that Ingram, by virtue of his participation i n
t h e d e a l , h a d become a temporary insider w h o inherited a Cady, Roberts duty. ! d . Earlier,
in SEC v. Lund, 570 F. Supp. 1 397, 1 399-400 ( C . D . Cal. 1 98 3 ) , a corporate insider asked
Lund i f he was interested i n participating i n a lucrative joint venture with the corporation.
Lund declined to join in the deal but purchased stock in the corporation, realizing a $ 1 2,500
profit. The d istrict court found that Lund was guilty of insider trading, holding that the
i nsider's approach to Lund made him a temporary i nsider of the corporation and imposed
upon him the obligation to keep the i n formation confidential. !d. at 1403. B u t see Walton v.
Morgan Stanley & Co. , 623 F.2d 796, 799 ( 2d Cir. 1 980) ( holding that fi nancial advisor of
acquiring entity has no duty to target entity even when target disclosed confidential infor-
218
[ Vol. 26: 1 7 9
confidential corporate information about the issuer i s , in these sit
uations , generally subj ect to an appropriate confidentiality agree
ment that prevents the white knight from trading on the basis of
the information obtained, there is nothing to prevent a prospective
white knight from rej ecting the suitor's advances and purchasing
target stock based on the knowledge that the target is seeking an
acquirer or " shopping the company. " 176 These initial contacts may
precede public disclosure by the corporation that it is a target.1 7 7
III.
THE BASIS FOR THE INSIDER TRADING P R O H IBITION
The foregoing analysis of the Ches tman decision demonstrates
the gap that has developed between the regulation of insider trad
ing and the traditional goals of the securities laws. It also calls into
question what should be done to regulate insider trading regula
tion. Development of the existing case law has been logically incon
sistent and possibly unfair, a result that is hardly surprising in the
absence of any clear statutory or common-law prohibition. Com
mentators have observed that the law is sorely i n need of clarifica
tion; many have called for a clear definition of the prohibited con
duct.178 This outcry requires some reflection on the basic rationale
for prohibiting insider trading. 179 If there is no clearly defined pro
hibition, why have the courts and the SEC decided that insider
trading is i llegal? Are they correct? In other words , having deter
mined that section 10(b) does not provide an appropriate basis for
prosecuting misuse of inside information, we are left to question
mation to advisor for express p urpose of exploring acquisition deal with d i fferent acquiring
entity).
1 76
Whether the firm's trading violated SEC Rule 14e-3 would b e a separate issue. See
supra note 1 50 ( discussing Rule 1 4 e - 3 ) .
177
I n the initial stages a corporation is typically shopped through a n i nvestment banker
without d isclosure of its identity to avoid this kind of trading. Many i n the i ndustry believe
that i f those approached can ascertain the identity of the company being shopped, they are
free to trade.
1 78
See supra note 5.
m In considering the purposes of regulating insider trading, this A rticle will not consider
the general objectives behind the antifraud provisions. Those objectives h ave been described
as including the p rotection of public investors against overreaching by issuers, the enhanced
market efficiency that results from i ncreased disclosure of relevant corporate i n formation,
and the regulatory function ascribed by J ustice Brandeis to disclosure as a d i rect deterrent
to fraud. See Lours BRANDErs. OTHER PEOPLE's MoNEY AND How THE BANKERS UsE I T 62-63
( 1933) . For a general d iscussion of the functions of the antifraud p rovision and c itation to
the relevant legislative history, see B rudney, supra note 13, at 334-36.
·
INSIDER TRADING
1 99 1 ]
219
whether such a prohibition is desirable and, i f so, what form it
should take.
A.
ECONOMICS, FAIRNES S , AND PROPERTY RIGHTS: POPULAR RATIONALES
F OR REGULATION
Scholars have debated at great length whether insider trading
sh ould be regulated. Although an extensive analysis of this debate
is beyo nd the scope of this Article, the battle lines are commonly
drawn between those commentators who believe that insider trad
ing increases the efficient operation of the markets and those who
view insider trading as harmful to the markets, the firms whose
sec urities are traded, or both. Professor Henry Manne has been
gen erally credited1 80 with focusing the insider trading debate by
rejecting criticisms of insider trading in terms of fairness and in
stead basing the analysi s on the perceived costs181 and benefits 182
1 80
HENRY G. MANNE, INSIDER TRADING AND THE STOCK MARKET v i i - v i i i ( 1 966) ; R a y A .
Schotland, Unsafe a t A ny Price: A Reply t o Manne, Insider Trading and the Stock Market,
53 VA. L. R E v 1425 ( 1 967); Henry G. Manne, Insider Trading a n d t h e Law Professors, 2 3
VAND. L. REv. 547 ( 1 970) ; see, e.g. , Carlton & Fischel, supra note 1 7 3 , a t 8 5 7 n . l (citing
Manne's book as " starting point" for subject) : Carney, supra note 7 1 , a t 863 n.2 (citing
Manne's book as " seminal"); Langevoort, supra note 26, a t 1 n . 1 ( citing M an ne 's book as
initial source for article).
1"1
It has been suggested that insider trading causes a decl i n e i n i nvestor confidence and
ultimately a decrease i n the flow of money to the capital markets. As the Supreme Court has
observed, " [w ] ho would knowingly roll the dice in a crooked crap game? " B asic, Inc. v.
Levinson, 485 U.S. 2 24, 247 ( 1 988) (citation omitted) . Moreover, one of the congressional
purposes in adopting the federal secur ities laws was to restore i nvestor confidence in the
securities markets. See, e.g. , In re Faberge, Inc., 45 S.E.C. 249, 254 ( 1 973) ("One of [the
Exchange Act's] p rimary objectives was to restore and maintain i nvestor confidence in the
capital markets of the United S tates. " ) ; see a lso Securities Exchange Act of 1 934, § 2 , 1 5
U.S.C. § 78b ( 1 988) (explaining " [n ] ecessi ty for regulation " ) ; cf. Spencer Cerek, Note, In
sider Trading, SEC Decision-lvfa k i ng, a n d t h e Calculus of Inuestor Confidence, 16 HoFSTRA
L. REv. 665, 675 ( 1988) (arguing that SEC's emphasis on high-profile i nsider trading prose
cutions may do more harm than good with respect to investor confidence ) .
In addition, t h e ability t o engage i n insider trad ing m a y create perverse incentives for
corporate management, encouraging management to manipulate corporate decisions in order
to create trading opportunities and to delay reporting of operations to accommodate trading
by insiders. The former problem is commonly described as " moral hazard." See, e.g. , Saul
Levmore, Securit ies a n d Secrets: insider Tra ding a n d t h e Law of Contracts, 68 VA. L. REv.
1 1 7, 149 ( 1982) ( arguing that insiders can structure corporate transactions i n order to profit
from a decrease in corporate stock prices ) ; Schotlan d , supra note 1 80 , at 1 4 5 1 (discussing
belief that insider's trad ing i n shares may i mpede insider's commitment to corporation 's
business ) ; ,Joel Seligman , The Re,form u la t ion of Federal Securit ies Law Concerning Non
pu b lic Inform a t i o n , 73 GEO LJ. 1 083, 1095 ( 1 98.5) ( d iscussing inside trader's ability to ma
nipulate release of news, adopt riskier practices t o detriment of shareholders, and profit by
.
220
[Vol. 26: 1 79
of such trading. This analysis, while interesting on a theoretical
level, has not generated any clear consensus, probably because of
the absence of empirical data. 183 Unless the effect of the legaliza
tion of insider trading on investor confidence or management be
havior can be quantified, it is impossible to determine whether
such effects justify retaining the existing prohibition. 184
Alternatively, the debate can be returned to the issue of fairness.
A common view of insider trading is that it is unfair to other trad
ers. Insiders possess an informational advantage by virtue of their
p osition or through fortuity and should not reap a windfall by us
ing that information for personal gain. 1 85 Whether other traders
bad as well as good events ) ; Anabtawi, Note, supra note 5 , at 386 ( arguing that where moni
toring b y shareholders i s costly and shareholder and management i nterests are not the
same, managers may fail to maximize shareholder wealth ) . Section 1 6 (c) of the Exchange
Act, which prohibits short sales by corporate insiders, has been cited as a congressional
attempt to deal with the moral hazard problem. E.g . , The!, supra note 1 9 , at 476.
For a discussion of the possibility that insiders may delay d isclosure to enhance their
personal trading, see Bainbridge, supra note 22, at 50- 5 1 ; Cox, supra note 39, at 636-37;
Robert J . Haft, The Effect of Insider Trading R ules o n t h e Internal Efficiency of the Large
Corpora tion, 80 MICH. L. REv. 1 05 1 , 1 053-60 ( 1 982 ) ; Kenneth E . Scott, Insider Trading:
Rule J Ob-5, Disclosure and Corpora t e Pri!J·acy, 9 J . LEGAL STUD. 80 1 , 8 1 0- 1 8 ( 1980).
'"" Free-market advocates claim that insider trading i ncreases the use of i nformation i n
the markets and thus causes stock prices t o become more accurate. Several commentators
have made the argument that insider trading is a form of executive compensation and, be
cause of the type of trading opportunities created, may lead to desirable management be
havior. E.g . , Carlton & Fischel, supra note 173, 870; Ronald A . Dye, Insider Trading a nd
Incen tives, 57 J. Bus. 295, 298-308 ( 1 984) ( providing formal econometric analysis) .
' 8 3 See, e.g. , B a inbridge, supra note 22, at 63-65.
' "' See Easterbrook, Stlpra note 37, a t 338 ( arguing that questions of whether i nsider
trading restrictions are j ustified are ultimately empirical) .
' " 6 M a n y also believe that insider trading d irectly hurts conte mporaneous traders in the
market by causing them to trade at an improper time or p rice. See, e.g. , W illiam K.S. Wang,
Trading on Impersonal Stock Ma rkets: Who is Harmed, and Who Can Sue Who m Under
SEC R u l e l Ob-5, .54 S. CAL. L . REv. 1 2 1 7 ( 1981 ) . P rofessor Wang has argued that i nsider
trading may have the effect of inducing others to trade or preempting the trades of other
i nvestors. Id. at 1 235-36. He explai ns that all trading i n securities is subject to the " law of
conservation of secu r i ties," under which the profits gained by an insider m ust be directly
offset by lo8ses sustained by other investors. Id. at 1 235. Professor Wang concludes that, i f
insiders profi t , other investors m u s t b e harmed, although i t may b e difficult to determine
who those investors are. !d. at 1 236-38. But see Bainbridge, supra note 22, a t 42-45 (arguing
that i nsider tnJ d i ng causes securities to be p riced more accurately i n situations in which
corporation is permi tted to w ithhold material information) ; Easterbrook, su pra nute 37, a t
3 2 4 - 2 7 ( arguing that insider trading is unlikely to result in unfair transactions for other
traders) ; G i lson & Kraakman, supra note 1 1 , at 6:30-34 (arguing that insider t r ad i ng is u n
l ikely t o have any effect on market p r i c e u nless p rivate information is e ffectively transmit
ted to mar k e t ) .
1 99 1 ]
INSIDER TRADING
221
are harmed directly, such as b y inducement to trade at an incor
rect price , or indirectly, through the presence in the market of
other traders who possess an overwhelming informational advan
tage, inequality of information is at the heart of the fairness ra
tio n ale. Yet, few suggest that insider trading be regulated by a par
ity - of-information standard.186 Instead, the unfairness associated
with insider trading has been attributed to inequality of access to
information. 187 As Professor B rudney explains, the unfairness asso
ciated with the insider's use of corporate information is based on
the fact that the insider has a "lawful monopoly on access to the
inform ation involved . . . which cannot be competed away. " 1 8 8
Apart from insiders who gain access to information by theft or
its equivalent, when does the insider's access to information make
his trading activity unfair ? 1 89 Obviously, participants in the market
1 86
At least one commentator has suggested that Congress enact a parity -of-information
approach by statute. Seligman, supra note 1 8 1 , a t 1 1 37 -40.
1 87
The Supreme Court has expressly rejected the theory that all traders are entitled to
equal information. See D irks v. SEC, 463 U.S. 646, 657 ( 1 983) ("Judge Wright correctly read
our opinion i n Chiarella as repudiating any notion that all traders must enjoy equal infor
mation before trading: ' [T ] he "information" theory is rejected . ' " ) (quoting Dirks v. SEC,
681 F.2d 824, 837 (D.C. Cir. 1 98 2 ) , r e u 'd, 463 U . S . 646 ( 1983 ) ) .
Although many argue that the level-playing-field theory i s addressed not t o equal i nfor
mation but to equal access, the Court in Chiarella also rejected unequal access to informa
tion as a basis for imposing liability. Chiarella v . United States, 445 U . S . 222, 235 n . 20
( 1980 ) . Even the Second C ircuit, with its expansive view of i nsider trading, does not take
the position that the regulation of insider trading is designed to equalize access to i n fo r m a
tion. "We do not say that merely using information not available or a ccessible to others
gives rise to a violation of Rule 1 0b-5 . . . . There are d isparities in knowledge a nd t h e
auailability thereof at many levels of market functioning that the law does not presume to
address." U n i ted S tates v. Carpenter, 791 F.2d 1 02 4 , 1 0 3 1 (2d Cir. 1 986) ( em p hasis added ) .
188
Brudney, s upra note 1 3 , at 346.
18 9
It is unclear why disparate access to information and the exploitation of that ;c, c c e s s
present a unique problem in the securities indus try. Business transactions are routinely
predicated on the fact that one party to the transaction has superior information of which it
intends to take advantage. An obvious example is the series of real estate purchases that
gave rise to the i nsider trading opportunity in the Texas G u lf Sulphur case. SEC v. Texas
Gulf Sulphur Co., 4 0 1 F.2d 833, 844 (2d Cir. 1 968) (en bane) , cert . denied, 394 U . S . 976
( 1969 ) . Texas Gulf Sulphur was buying land because of its superior knowledge that there
were extraord inary mineral deposits in that land, without revealing its d iscovery to t h e sell
ers. Id . Although the purchases may have been unfair to the sellers, they surely wen; not
fraudulent. Indeed, the Ontario H igh Court of Justice, i n a case arising out of the s c: m e
factual situation as that l itigated before the Second Circuit, found that Texas Gulf Su lphur
had done what any prudent m ining company would do i n pursuing the purchases w i t h o u t
disclosing the d iscovery. Leitch Gold M ines, Ltd. v. Texas Gulf Sulphur C o . , 1 O . H . 4 6 9 .
492-93 ( 1 969 ) . For a further discussion, see Anthony Kronman, Mis t a k e , Disclosure. Infor
ma tion, a n d t h e Law of Contra c t s , 7 J. LEGAL STUD. 1, 20- 2 1 ( 1 978).
222
[ Vol. 2 6 : 1 7 9
do not possess equivalent information. For example, the average
analyst or other market professional has a great deal more infor
mation about the stocks he trades than the average small investor.
Although this inequality may be unfair/9 0 it is not seriously sug
gested that analysts be precluded from taking advantage of this
informational asymmetry. 191 M arket professionals expend a great
deal of effort trying to obtain information that does not duplicate
what everyone else has, 192 through discussions with corporate in1 90
E v e n advocates of the e q u a l access theory of regulation accep t t h a t there is " system
atic inequality of lawful access to i n formation by reason of disparities among i n d ividual
investors with respect to power, wealth, d iligence, or i n telligence." B rudney , supra note 1 3 ,
a t 360. I t has been suggested that the u n fairness o f a llowing investment analysts t o trade on
and sell superior i n formation i s addressed by the fact that, while every i nvestor cannot be
come a corporate insider or the confidante of such an insider, everyone can obtain the ser
vices of an i n vestment analyst. Donald C . Langevoort, Inves t m e n t A n a lysts and the Law of
Insider Trading, 76 VA. L . REv. 1 02 3 , 1 0 3 2 ( 1 990) . Therefore, all i n v estors do have access to
analyst i n formation.
This argument overlooks two factors. F i rst, even among the customers of an i n vestment
analyst, there i s asymmetrical access to i n formation. Many analysts selectively allocate the
i n formation they obtai n , auctioning valuable i n formation off to t h e h ighest bidder, or dis
closing the most significant i n formation only in oral conversations with favored clients. The
i n formation received by the typical investor, such as i n the form of the fi r m 's newslette r , i s
often markedly i n ferior. ! d . a t 1 039. I n d e e d , i n the Dirks case, i t was D irks's allocation o f
h i s information t o his large institutional clients a t t h e expense o f smaller i nvestors t h a t t h e
D istrict of Columbia Circuit found t o b e u n fair. Dirks v. S E C , 6 8 1 F . 2d 8 2 4 , 84 1 ( D . C . C i r .
1 98 2 ) , rev 'd, 4 6 3 U . S . 6 4 6 ( 1 983).
Second, the customers of an investment analyst pay for the i n formation they obtain.
While an analyst is not an absolute free rider, i t is unclear why h e s hould b e compensated
for the information acquired. That is, why h as the analyst acquired some sort of property
r ight in the i n formation by virtue of the tip? Even if the analyst system achieves market
efficiency, why is i t socially preferable to allowing corporate insiders to sell i n formation di
rectly to the public?
19 1 A
naiysts may garner personal advantage from trading for their p roprietary accounts,
from bonuses and other compensation schemes that reward superior i nformation, and from
benefit to their reputations. Moreover, because superior i n formation generates greater busi
ness and the market for financial services is highly competitive, an a nalyst who has access to
inside information furthers his career substantially. See Langevoort, sttpra note 1 90 , at
1 042-43.
1 " 2 The average small investor is a u tomatically a t a d isadvantage due to his inabil ity to
follow the market and its developments on a full-time basis. C harles C . Cox & K evin S.
Fogarty, Bases of Insider Trading, 49 O H I O ST. L.J. 353, 360 n.23 ( 1 988 ) . Some scholars,
such as Professor Brudney, would not b e concerned with this d is parity , arguing that the
relevant d istinction is not equality of i n formation but equality of access and that as long as
any investor may, through expending sufficient resources, obtain the e q uivalent information,
the investment professional's i n formational advantage is not unfair. B rudney, supra note 1 3 ,
a t 322. This argument begs t h e question: Should t h e inquiry focus o n actual access o r theo
retical access ? See Easterbrook, supra note 37, at 330 ( pointing out that access to i n forma
tion is fu nction of cost of obtaining i n formation and that inequality of access is thus natural
19 9 1 ]
INSIDER TRADING
223
siders , following the progress of important litigation , or monitoring
news reports and the Dow Jones tape constantly. 1 9 3 Should the
arbitrageur who keeps close watch on an important lawsuit be pre
cluded from trading as soon as the court announces its ruling be
cause he has an informational advantage over the rest of the in
vesting public? 1 94
If not, how can legal informational advantages be distinguished
from those that form an impermissible basis for trading? 1 9 5 The
method employed by existing legal theory is to brand as impermis
sible those informational advantages acquired through the breach
of a fiduciary duty. Yet, for the investor-victim, it is irrelevant
whether the trader has acquired inside information through the
breach of a duty or not; anyone who trades based on superior in
formation not available to the investing public has obtained a trad
ing advantage that is arguably unfair . 1 96 Moreover, as previously
result of unequal d istribution of i ntelligence, wealth, and investment of human capital).
1 9 3 Indeed, arbitrageurs go much further, attempting to ferret out i n formation directly
from corporate insiders. A n arbitrageur's assessment of an investment opportunity may be
based en factors that include not merely what an insider says, but also his " tone of voice,
. . . the way a question was answered or avoided, or . . . the fact that a telephone call was
not returned . " Sarah Bartlett, Business a n d Law: Cases Illustrate Wa li S t . 's Edge, NY
TIMES, Aug. 28, 1 989, at D2.
1 9 ' As Professor B rudney observes, the search for relevant corporate and economic infor
mation is a service of value to the functioning of the capital markets. The search entails
research costs that will not be allocated for that purpose unless the i nvestor is able to re
ceive the rewards of the i n formational benefits so obtained. Brudney, supra note 1 3 , at 341 .
On the other hand, it is possible that the selective favorable treatment of the fi nancial com
munity leads to excessive research and competition for superior information.
1 96
This question assumes that all informational asymmetry is not unfair. Although the
Supreme Court has rejected the level - playing-field underpinning for insider trading regula
tion and has refused to uphold l iability in the absence of a breach of duty, see supra note
187, Congress could choose to impose such a standard.
1 96
An example of trading that appears i mproper but i nvolves no breach of a fiduciary
duty is pre-offer trading by a prospective tender o fferm. When an individual who is about to
make a tender offer for the stock of a target company purchases stock p rior to announcing
the tender offer, h e is, in some sense, trading on inside i n formation about the forthcoming
announcement, but since the bidder owns the i nformation , the trading is legal. See C hiarella
v. Un ited States, 445 U.S. 222, 2 ::l 1 -32 n . 14 ( 1 980) ("The Court of Appeals for the Second
Circuit previously held, in a manner consistent with our analysis here, that a tender offeror
does not violate § l O ( b ) when it makes preannouncement purchases precisely because there
is no relationship between the offeror and the seller . . . . ") (citing General Time Corp. v.
Talley Indus., 403 F.2d 1 59, 164 (2d Cir. 1968 ) , cert. denied. 393 U.S. 1 026 ( 1 969 ) ) . Yet, if
the bidder tells a friend about the offer, which, as owner of the information, he should be
entitl ed to do, and the friend proceeds to trade in the t arget company's stock, the friend's
trad ing violates Rule 1 4e-3. See supra note 1 50 (discussi ng Rule l 4 e -::l ) .
2 24
[Vol. 26: 1 7 9
discussed, neither the insider 's fiduciary duty to the firm nor the
misappropriator 's duty to the source forms a logical and consistent
justification for prohibiting trading. Most importantly, in this re
gard, applying the Court's rules regarding fiduciary duty requires
reference to the parties' private agreement. For example, if the
Wa ll Stre e t Journa l had not had a rule maintaining the confiden
tiality of its columns, \Vinans would not have breached a fiduciary
duty by trading on the information contained in those columns.
Similarly, if a corporation, through charter amendment, stock
holder vote , or the equivalent, authorized its management to trade
on the basis of inside information, there would be no breach of
management's duty to stockholders upon which to predicate classi
cal insider trading liability.19 7
This analysis has led some commentators to view insider trading
in terms of property rights . 1 98 If corporate information is consid
ered the property of the firm, then the conversion of the property
for the insider's personal use is a theft. 1 99 Under this theory, an
insider or misappropriator is a thief, and his tippee is receiving
stolen property. 2 00 The property rights theory provides a justifica
tion for prosecuting W inans for stealing information about upcom
ing columns from his employer, even though the Wa l l Stree t Jour
nal would have been free to trade on the information in
question. 2 0 1
1 9 7 Although i t is rarely argued t h a t corporations should be able t o authorize insider trad
ing d i rectly by treating corporate i n formation as property and contractually bargaining with
management about the allocation of rights i n that property, some com mentators assert that
corporations would be able to authorize such trading indirectly by relieving management of
a fiduciary obligation not to trade. E.g. , Nicholas Wolfson, Trade Secrets a n d Secret Trad
ing, 25 SAN DIEGO L. REv. 95, 1 1 3 ( 1 988).
' 98 S e e . e.g . , Carlton & Fischel, supra note 1 73, a t 86 1 ; Easterbroo k , s upra note 3 7 , a t 3:3 1 ;
Edmund W. K i tch, The Law a n d Economics o f Righ ts i n Va luable Informa tion, 9 J . LEGAL
STUD. 683, 7 1 8 - 1 9 ( 1980 ) ; Lawson, supra note 1 25 , at 7 59 ; Macey, supra note 44, at 9; Rich
ard J . Morgan, Insider Tra ding a n d t h e Infringement of Property R ig h t s , 48 O H IO ST. L.J.
79 ( 1 987 ) .
1 9 9 Additionally, u s e of t h e i n formation by the insider m a y impair the corporation's abi l
i t y t o exploit it further. T h e corporate owner may require that confidentiality be maintained
i n order to profit fully. See, e.g. , SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 ( 2d Cir. 1 968)
( fi nd ing that corporation mainta i ned confidentiality of drilling results i n order to confirm
results and acquire land ) , cert. denied, 394 U.S. 976 ( 1 969 ) .
'0 " Lawson, supra note 1 25, a t 767 ( " M r . Levine was thus a garden - variety thief, and M r .
Boesky, w h o traded on the information and s p l i t t h e profits w i t h Mr. L e v i n e , was a fence . " ) .
' " 1 According t o t h e defendants in Carpenter, this anomaly meant t h e i r trading couid not
violate the law. The court responded by explaining that, while the .Jo u rn a l m ight lawfully
l
l
j
·i
1
l
1 99 1 ]
INSIDER TRADING
225
The property rights approach also offers a method for dealing
with two of the examples posed earlier: that of the corporate sup
plier and that of the prospective white knight. 202 While neither has
unilaterally created the inside information in the sense that would
give rise to an unequivocal ownership i:1terest, both are trading on
th e basis of information voluntarily imparted by a third p arty for
the purpose of business dealings. The third p arty has the opportu
nity to preclude trading on the basis of those dealings by contract,
thereby restricting property rights in the information. Absent such
a contractual provision, there is no misuse or theft in trading on
the information.
A more troubling aspect of treating inside information as prop
erty is that such treatment does not j ustify government interven
tion to allocate the property rights to information. If inside infor
mation is the property of the firm producing it, why is it different
from any other firm property, which the firm may allocate, as it
chooses, by contract?203 This view would enable a firm to authorize
its officers or employees to trade on the basis of inside information.
The firm would, in effect, be opting out of the government enforce
ment of its property rights. 204 In other words, viewing inside infor
mation as property justifies treating the misappropriation of that
undermine i ts reputation by trading on the basis of its knowledge of forthcoming publica
tions, " its employees should be and are barred from destroying their employer's informa
tional property." United States v. Carpenter, 791 F.2d 1 024, 1 033 (2d Cir. 1 986).
' " " S e e supra text accompanying notes 169- 1 7 7 .
203 T h i s argument is detailed i n t h e seminal article by Professors Carlton a n d Fischel.
They argue that insider trading would b e regulated more efficiently i f firms were free to
authorize insiders to trade. Carlton & F ischel, s upra note 173, pass i m . Professor Fischel and
Judge Easterbrook have observed that p r ivate contract theory may not achieve optimal allo
cation of the property rights i n i n formation due to a variety of factors, including the diffi
culty i n enforcing contracts that restrict insider trading because of the practical problems of
detecting improper trades. Frank H. Easterbrook, Insider Trading as a n Agency Problem,
in PRINCIPALS A N D A GENTS THE STRUCTURE OF BusiNESS 8 1 , 90-97 (John W . P ratt & Richard
J. Zeckhauser eds . , 1 985) [ hereinafter Easterbrook, Agency Proble m ] ; Easterbrook, s upra
note 37, at 332-35; Frank H. Easterbrook & David R. Fischel, Trading on Inside Informa
tion, 36 LAw ScH. REc. 10, 14 ( 1 990) .
Although these observations m a y explain why firms have n o t chosen t o regulate i nsider
trading by private contract, they do not j ustify a government ban on such contracts. " Public
enforcement of antitheft laws does not imply that consensual transfers of property ought to
be forbidden; j ust so with inside trading rules." !d. at 1 4 .
20 1 Addi tionally, t h e fi r m would be able to sell the i n formation t o others. S e e Jonathan R .
Macey, From Ju dicial Solutions to Political Sol u t ions: The New, New Directions o f t h e
R u les Aga inst Insider Trading, 39 ALA. L. REv. 3 5 5 , 376 ( 1 988).
226
[Vol. 2 6 : 1 7 9
property as theft but correspondingly requires the government to
defer to firm decisions contractually allocating the entitlement to
that property.205
If the wrong associated with insider trading is a harm to the is
suer or to the source, as suggested by the classical and misappro
priation theories, respectively, the harm m ight b e addressed
through a regulation that protects property rights i n information
but allows firms to bargain away those rights voluntarily, restrict
ing the government's i nvolvement to enforcement of the privately
negotiated bargain.206 B ut perhaps existing theories o f insider trad
ing misapprehend the significance of insider trading. Is the ration
ale for the public perception that insider trading i s wrong actually
based on a perception that corporate insiders damage the i ssuer
when they trade? This perspective seems unlikely. It is more plau
sible that the public views insider trading as damaging to traders
and to the trading markets. The insider , by virtue of his p osition,
has obtained an unfair informational advantage over o ther tra ders.
Thus, the traditional views of insider trading distort the doctrine
by ignoring the concepts of market duty and market harm.
B.
JUSTIFYING REGULATION ON THE BASIS OF AN I N S I D E R ' S D UTY TO
THE MARKET
It might be argued that the C ourt in Chiare lla rej e cted a general
duty of disclosure to the market and that such a d uty, therefore,
' " 5 According t o Coase's theorem , i n the absence of substantial transaction costs , p roperty
rights will be transferred to t hose who can exploit them most p ro fitably. See genera lly
David D. Haddock & Jonathan R. Macey, A Coasian Model of Insider Trading, 80 Nw. U
L REv. 1 449 ( 1 987 ) (concluding, based on Coasian analysis, that ordinary s hareholders
would be better off i f firms were allowed to opt out of proscriptions of current insider trad
ing law ) . The SEC has not taken the position that i n formational rights can be transferred as
property. For example, SEC Rule 14e-3 is i n consistent with the p roperty rights approach
because it prohibits a b idder from consensually transferring i ts p roperty rights i n informa
tion about a prospective tender offer to t h ird parties. See, e.g. , 17 C . F . R . § 240. 1 4e - 3 ( 1 99 1 ) ;
Morgan , supra note 198, a t 1 1 3 (arguing that, under a property rights approach , bidder
should be free to do whatever h e wants with such information, including giving it to others ) .
20"
This approach would address the concern that private e n forcement is too d i fficult and
costly to be effective i n banning insider trading, even where such trad i n g is inefli cient. See
Easterbrook, Agency Pro ble m , supra note 203, at 94-95 ( arguing that, if fi rm cannot meet
costs of establishing program to prohibit i nsider trad ing and o f detecting i m p roper trades, it
is unl ikely to adopt private prohi bition, even where prohibition is socially beneficia l ) . See
genera l ly supra note 203.
INSIDER TRADING
19 9 1 ]
227
cannot be the basis for imposing insider trading liability. 20 7 There
are two responses to this argument. First, the Court in Ch iare lla
r eje cte d the concept that everyone, corporate insider or not, has a
gen eral duty to the market.208 The Court, however, did not con
sid er the specific question of whether a corporate insider such as
an offi cer or director, by virtue of his position, has a duty to the
tra ding market not to misuse nonpublic information.
Sec ond, the Chiarella decision represents an interpretation of fi
duci ary duties under the existing statutory language of section
10(b) . 209 As demonstrated earlier, section l O (b) is a poor statutory
choice for regulating insider trading. 210 I f regulation is to be ef
fected by a new statute, however, the limitations of Chiare lla need
not apply. l'vloreover, if we are engaged in a search for an appropri
ate statutory definition, i t seems appropriate to tie that definition
to the rationale for regulation. Finally, imposing a market duty
upon insiders is consistent with the overall structure and objectives
of the federal securities laws, which are aimed primarily at the pro
tection of investors and the capital markets , not at the protection
of such fiduciary relationships as the physician-patient
relationship. 2 1 1
Accordingly, a revised statutory approach to insider trading reg
ulation can be predicated on the theory that a corporate insider
has a duty to the marketplace not to misuse nonpublic informa
tion . Why is the insider's use of non public information unfair? The
answer can be explained, in part, by the importance of the capital
markets to the large publicly held corporation. Absent a system in
which corporations have ready access to capital markets, access
which is facilitated by the availability of safe, liquid , regulated
markets for secondary trading, the public corporation would be un
likely to attain the same size and dominance. This growth , in turn,
provides management with unparalleled opportunities for wealth
and status. Thus, in a sense, the corporate insider's superior ac
cess, due to his position , may be partially attributed to government
and public participation in the markets. It is the fact that an in-
""' See Chiarella
v.
United States, 445 U.S. 222, 2 3 1 , 233 ( 1 980)
( rej ecting duty o f
C h i ar e l l a " to the m a r k e t a s a whole " ) .
too Jd .
"0"
210
"11
See
id. at 2 3 2 - 35 (premising h o l d i n g on l a nguage of section 1 0 ( b ) ) .
See s u pra Part
II.
See U n i t e d States
v.
W i l l i s , 737 F . S u p p .
269, 272 ( S . D . N . Y 1 990).
2 28
GEOR G IA LA W RE VIE W
[ Vol. 26: 1 7 9
sider has obtained his i nformational advantage because of his posi
tion, and the fact that this position is attributable to the presenc e
of other less-privileged transactors in the market, that makes the
insider's use of nonpublic information unfair. This conclusion does
not necessarily imply that other market transactors are hurt by in
sider trading.2 1 2
A POLITICAL EXPLANATION FOR RE GULATI ON O F INSIDER TRADI N G
C.
Before considering the new proposal, it is necessary to consider
one additional factor: why the status quo prohibits insider trading.
The preceding analysis suggests that the proffered j ustifications for
regulating insider trading, particularly under the e xisting statutory
scheme, are unconvincing. Yet in spite of the logical i nconsisten
cies, insider trading enforcement continues as a high priority, and
the SEC continues to expand its enforcement efforts with more ag
gressive prosecutions and calls for stiffer sentences. The expansion
of liability under section l O (b) is particularly surprising in view of
the fact that the objectives of existing insider trading theory could
be achieved more precisely by strengthening state law doctrines of
fiduciary duty,213 coupled with the existing federal prohibition on
short swing trading and short sales by corporate insiders.2 1 .1 B efore
attempting to address the deficiencies in the existing regulatory
scheme , it is important to understand the reasons for its evolution.
This question can be answered, in part, by looking to who benefits
from insider trading regulation.
This Article contends that at least three major interest groups
are beneficiaries of the existing regulatory scheme. One of these
�12
B u t cf. supra note 1 8 5 ( c i t i n g partici pants i n d e b at e over w h e t h e r i n s i d e trad i n g
harms o t h e r marke t transactor s ) .
213
M any commen tators, of course, v i e w state law as a n unsatisfactory m e t h o d o f d i s c i
p l i n i ng corporate i n s i ders because of general i nstitutional fa i l ures s u c h a s the i n e ffective n ess
o f the derivative s u i t and other tools for e nforcement o f state- law fiduciary d u t i e s . See, e.g. ,
.J i l l
E. Fisch, Fra nkens t e i n 's Monster Hits the Campaign Tra il. An Approach to Regu la tion
of Corpora t e Political Expendi t u res, 32 W :vt & MARY L. REv. 5 8 7 , 638 n n . 26 1 -63 ( 1 99 1 )
( c i t i n g articles w h i c h assert that vot i n g a n d derivative s u i ts d o n o t p r o v i d e s u ffi c i e n t s hare
holder control or m a n agerial accoun t a b i i i ty) . I n a d d i t i o n , t h e w i l l i ng n es s o f state legislatures
and courts to decrease protection o f shareholders in the i n terest o f attracting corporate
fr anc hises, the so- called race to the bottom, suggests that states w i l l b e slow to expand
fi d u c i ary principles to l i m i t i n s i d e r trad i n g activity. See id. a t 635 n n . 246-47 (arguing that
state l e g i s la t u res are influenced b y reve n u es of corporate fra nchise ta x ) .
·n • S e e su pra note 1 9 .
199 1 ]
INSIDER TRADING
229
groups is the securities analysts. S ecurities analysts earn their live
lihood by analyzing publicly available information215 and attempt
ing to determine when a particular security represents a good in
vestment. Because they have the time and expertise to acquire
superior information, analysts are at an informational advantage
ove r many members of the investing public.216 Moreover, under ex
isting insider trading law, securities analysts enj oy a position of
distinct legal advantage over the general public.217 After Dirks, dis
clos ure by corporate insiders to analysts for reasons other than
personal gain2 1 8 will be treated as lawful.219 This means that ana
lysts enjoy a unique position in the market-regular access to ma
terial nonpublic information220 without restrictions on its use.221
210
P u blicly avai l able information i s used i n its broadest sense in describing the work of
secur i ties analysts. Frequently, analysts have access to sources of information that are not
available to the general public. See supra notes 1 90 - 1 94 ( discussing disparity of information
among market participants ) ; see a lso B rudney, supra note 1 3 , at 365 ( questioning whether
analyst who makes overt i nq u i ries to firm's executives about future of company has received
nonpublic information).
" 6 Indeed, some commentators have described such market professionals as " quas i -insid
ers ' ' due to thei r persistent advantage over all other traders. E.g. , Macey, s upra note 204, at
377.
217
See Langevoort, supra note 190, at 1 024 (concluding that investment analysts receive
special treatment because of their perceived role i n increasing market efficiency ) ; Macey,
supra note 204, a t 377 (stating that market professionals who are perm itted, even en
couraged, to trade on basis of their lawfully acquired informational advantage benefit from
general proscription on insider trading).
2 1 " Langevoort, supra note 1 90, at 1023-24. As Professor Langevoort observes, there are
many reasons why an issuer m ight find i t desirable to d isclose i nformation through an ana
lyst rather than a press release o r SEC filing. See id. at 1028-31 (citing four reasons for
preferring d isclosure through analysts: ability to release substance without specifics, avoid
ing liability , overcom ing moral hazard, providing i ncentive to analysts ) .
" ' " Cf. S E C v. Stevens, 9 1 C i v . 1 869 ( C S H ) ( S . D . N . Y . M a r . 1 9 , 1 99 1 ) ; Ex - CEO, s upra note
143, at 439. I n S t e uens, an ex-CEO settled insider trading charges based o n selective tipping
to securities analysts. The SEC charged that the CEO tipped i n order to enhance h i s profes
sional reputation and his future earnings power as CEO. !d.
""" Many scholars have attempted to justify d isclosure of nonpublic info r mation to ana
lysts as in the best interests of the corporations. Among the arguments proffered are the
clai ms that such d i sclosure is faster, more credible, l ess expensive, and more accurate than
disclosure to the general public would be. E.g. , Daniel R. Fischel , Insider Trading and In
L>es l m e n t A n a lysts: A n Econ o m ic A n a lysis of D i r ks v. Securities and Exchange Commission,
1 3 H oFSTRA L. Rzv. 1 27 , 1 40-42 ( 1 984 ) ; Helen Garten, Insider Trading in the Corpora t e
Int eres t , 1 987 W i s . L. REv. 573, 625. This Article does n o t take t h e position t h a t selective
d isclosure is j ustified. See, e.g . , Langevoort, s upra note 1 90 , at 1023 ( arguing " special treat
ment" given to investment analysts under existing insider tradi ng l aw i s excessive and un
viarranted ) . Moreover, the SEC has indicated that it does not accept the notion that the
!Ji,- b· d e c i s i .J n gives corporate insiders carte blanche to make selective d isclosure to ana-
I
230
[ Vol. 26: 1 7 9
In an ideal world, the information provided by investment ana
lysts would be useless. P erfectly efficient markets would cause in
formational changes to be reflected immediately in stock prices,
with the result that an analyst could not, on the basis of public
information, provide advice that would produce a better-than -av
erage return.222 The continued use of i nvestment analysts can be
justified only by the conclusion that, under the current regulatory
scheme, analysts are able to provide superior information.223 Ana
lysts' ability to provide this information might be explained as
proof that the markets are not perfectly efficient.224 In the alterna-
lysts. SEC Commissioner Edward H . Fleischman, P resentation to University of California
1 3th Annual Securities Regulation Institute (Jan. 24, 1 9 9 1 ) [ hereinafter Fleischman, Presen
tation ] . Regulation requiring corporations to handle d isclosure through a n eutral method
such as press releases would address this u n fairness.
22 1
The special treatment of the analyst has been justified by the important role that
analysts play i n market efficiency. Congress explicitly stated that the Insider Trading and
Securities Fraud Enforcement Act of 1 988, Pub. L. No. 1 00-704, 102 Stat. 4677 ( codified in
scattered subsections of 15 U.S.C. § 7 8 (Supp. 1 988 ) ) , was not intended to cut back on the
deference to analyst tipping recognized by Dirks:
[The Dirks test was meant] to ensure that the insider trading laws do not in
hibit honest communication between corporate officials and securities analysts.
The Committee recognizes that market analysts play a crucial role i n facilitat
ing the d issemination of information to the marketplace, and thereby promot
ing smoothly functioning markets. This legislation is not intended to i nterfere
with these critical functions.
H o usE CoMM. oN ENERGY AND C o MMERCE, I N siDER TRADING AND SECURITIES FRAUD ENFORCE
'.IENT ACT OF 1 988, H . R . REP. No. 9 1 0 , 1 00th Cong. , 2d Sess. 19 ( 1988), ,- eprinted in 1 988
U . S . C . C .A.N. 6043, 6056. As Professor B rudney observes, the search for relevant corporate
and economic i nformation improves the functioning o f the capital m a rkets. Such a search
entails research costs that will not be allocated for that purpose unless the investor is able
to receive the rewards of the informational benefits so obtained. Brudney, supra note 1 3 , at
34 1 . On the other hand, i t is possible that the selective favorable treatment o f the financial
community leads to excessive research and competition for superior i n formation.
m Modern portfolio theory suggests that i t is i mpossible to outperform the stock market
systematically without the use of nonpublic information. See, e.g. , Macey, supra note 44, at
21 n.55.
m Professor Coffee explains that the disclosure provisions of the Securities Exchange Act
cf 1 934 actually subsidize the i nvestigatory activities of investment a nalysts by providing
them with extensive detailed information at low cost-information that is more useful to
the professional analyst than the individual trader. John C. Coffee, Jr., Market Failure and
r h e Economic Case for a Manda tory Disclosure Sys t e m , 70 VA. L. REv. 7 1 7 , 7 2 8 - 29 ( 1 984 ) .
""" See, e.g. , Stanford J . Grossman, On t h e Efficiency o f Cumpetitiue Stock Markets
Where Trc.des Ha ve Diverse Inform a t io n , 31 J. FIN. 573, 574 ( 1976 ) ; Stanford J . G rossman
& Joseph E. Stiglitz, Information and Competitive Price Sys tems, 66 AM. EcoN. REv. 246,
248 ( 1 9/6 ) . G rossman argues that i t would b e paradoxical to conclude that markets are per
fectly efficient given the superior information and returns attributed to analysts. H e there
fore concludes that analysts are able to d iscover information that is not fu l l y retlected in
I
j
'·I
.J
1
l
i
INSIDER TRADING
1 99 1 ]
231
ti ve, analysts may have access t o information that is not available
to the general public.225 The policy of permitting corporations to
ma k e disclosures by tipping analysts is one plausible explanation
of how analysts gain such access.226
Der egulation of insider trading would have two effects on ana
lysts , effects that this Article will describe as the "better source
effec t " and the " embarrassment effect. " The better source effect
reflects the fact that an analyst's information is seldom as good as
a true insider tip. In a world in which insider trading and tipping
are legal, investors would have access to a marketplace of better
information than that provided by analysts, rendering the analyst's
information second-rate. 227 The embarrassment effect results from
the fact that a free flow of inside information would result in the
entry into the marketplace of superior information to that pro
vided by the analyst-information resulting from tipping and in
formation generated by the occurrence of insider trades. This in
formation would be likely to make the analyst's information
appear dated and of poor quality. The derogation of the analyst's
information would generate the implicit message that the analyst
is not really a high-level specialist and does not provide a valuable
service to investors.228
A second group threatened by insider trading is the professional
stock p r i ces.
22
5
Indeed, through t h e i r practice o f selective d isclosure, analysts may further i n forma
tional d isparities in t h e market. A s P rofessor Langevoort observes, the analyst may favor
the high - paying i n st itutional investor over t h e retail c l i e n t . Langevoort, supra note 1 90, a t
1 04�3; see a lso F l e i schman, Presentation, s upra n o t e 220.
226
See supra notes 193, 2 1 5 - 2 1 8 . This p o l i cy does not, however, answer concerns raised
by advocates of the l e ve l - p l aying-fi e l d approach to the securities markets that analysts' pos
session of t h i s informational advantage is unfair. For exam p l e , the analysts i n S t euens did
not d isclos e their superior i n formation to the world; they simply told a few o f their favored
clients, who were a b l e to s e l l t h e i r hold i ngs in the computer and d efense equipment manu
facturer a n d avoi d losses. See Ex - CE O , supra note 143, at 4:3 9.
22 7
In countries i n which insider trading prohibitions are absent or loosely e n forced, the
value of inside information i s so s i g n i ficant as to cause investors to advertise for s u c h i n for
mation openly. See How Asia Regards Insider Trading: A wareness Up But Some Countries
Ca ll It Part of Business. LA TIMES, Mar. 28, 1 989, § 4 , at 9 ( describing p r actice i n New
Zealand of traders running newspaper ads openly asking for inside information a t h e i g h t of
pr e - O ctober 1 987 b u l l market).
'"" The e m barrass ment effec t partially explains why ana lysts feel the need to tread c lose
to the legal line by attempting to fe rret out informat i o n that i s not w i d e l y available
public.
See D i rks v. S E C , 4 6 3 U . S . 6 4 6 , 6 5 8 - 5 9 ( 1 9 8 : )) .
to
the
232
[Vol. 26: 1 7 9
investors.229 This diverse grou p m ight be viewed broadly as inclu d
ing risk arbitrageurs,230 broker-dealers trading for their own ac
counts,231 and institutional investors, such as mutual funds, pen
sion funds, and insurance companies. Investment p rofessionals
spend a great deal of money to acquire su p erior m arket and firm
information. Although they do not have the access of an inside r,
their resources enable them to be " next in line" in terms of quality
of information.232 To the extent that insiders are able to trade,
they preempt or reduce the p rofessional investors' informational
advantage.233
Stockholders of publicly held companies are also direct benefi
ciaries of the regulation of insider trading. The existing regulation
allows stockholders to be p assive. Stockholders need not weigh the
costs and benefits of allowing insiders to trade the cor p oration's
stock or monitor the agency p roblems that may result from such
trading.234 If insider trading p roblems were relegated to state - law
derivative suits , based on allegations of breaches of the insider's
fiduciary duty or duty of loyalty, the burden of enforcement would
be on stockholders. Instead , the SEC has assumed the enforcement
229
As Professor Langevoort explains, professional investors benefit from insider trading
regulation because they are " 'next i n line' [ after corporate insiders] w ith respect to the
opportunity to trade immediately upon d i sclosure. " Langevoort, supra note 5 , at 400 n.6.
2 3 0 Arbitrageurs generate profits through i n- depth monitoring o f corporations coupled
with large i nvestments when those corporations present "tradi ng opportunities." The arbi
trageur is rewarded when this monitoring results i n timely i n formation o f which h e can take
advantage by taking a large position before that i n formation is fully reflected i n the market
place. In a sense, the arbitrageur profits from the fact that the securities markets are not
perfectly efficient. The public announcement of material effects is not i m m e d i ately reflected
i n stock prices; the market requires an adj ustment period. Arbitrage u rs are threatened by
insider tradi ng because such trading is able to beat them at their own game. Not only can
insiders profit from i n formation before it is available to arbitrageurs, but the leakage effect
of their trading also may reduce the trading opportuni ty available to the arbitrageur.
23 1 To the extent that an analyst makes proprietary investment decisions as opposed to
rendering investment advice to others, this category overlaps with the previous one.
' 3 2 Langevoort, supra note 5 , at 400 n.6. P rofessional investors also serve as major cus
tomers of securities analysts.
2 3 3 This is not to say that the i n formational advantage of the professional i nvestor is a
bad thing. To the extent that professionals expend resources to gathe r securities i n forma
tion, they improve market efficiency. See Easterbrook, supra note 37, at 329-30 ( arguing
that i n formation is quickly reflected by stock prices and that it "would be a colossal waste i f
the information . . . had t o b e presented t o everyon e " ) .
"'' See, e.g. , Roberta Romano, Metapo litics a n d Corpora te Law Reform , 36 STAN. L . REv.
923, 1 004-0.S ( 1 98 4 ) (explaining that governm ent intervention to regulate insider trading ad
dresses stockholder free -rider problem and lowers agency costs) .
1 99 1 ]
INSIDER TRADING
233
r ol e. Absent this enforcement, stockholders would have to exercise
m ore vigilance in monitoring the extent and cost of insider trading
in their corporations. Moreover, returning insider trading regula
tion to the purview of such common-law doctrines would rekindle
th e ongoing debate over the efficacy of using the stockholder deriv
ative suit to enforce insiders' fiduciary duties to the corporation.235
Most importantly, the general public, unexposed to m any of the
le gal analyses d iscussed above, appears to believe that insider trad
ing is harmful to the markets . The concepts of insider trading as
. unfair, as misappropriation of corporate property, and as destruc
tive of investor confidence, while controversial and vigorously de
bate d among scholars,236 reflect the perception of the average
stockholder. Stockholders, rightly or wrongly, are likely to view in
sider trading regulation as an effective way of disciplining their
corporate managers with little cost or effort.
This feeds into the p opular mentality23 7 that "greed is bad. "238
In the view of typical members of the public, someone who trades
on inside information obtains a benefit from information for which
he has not paid, information in which the trader has no ownership
interest or other legitimate expectation of gain. The successful in
side trader has won the lottery without buying a ticket. While they
may be jealous of the trader's good fortune, typical members of the
public see no reason to approve of activity in which they cannot
also participate and which leads to what they perceive as unde
served gains. 239
Thus, it is p ossible to identify at least three politically signifi
cant groups that benefit from the current regulation of insider
trading. Securities analysts and professional investors support in230
For a sampling of the l iterature addre5sing whether the derivative suit effectively de
ters management misconduct, see Daniel R . Fischel & Michael Bradley, The R o le o f Liabil
ity R ules and t h e Derivative Suit in Corporate Law: A Theore tica l and Empirical A n a ly
sis, 71 CoRNELL L. REv. 26 1 , 262 n.2 ( 1 986) .
236
237
See supra note 1 8 1 .
See Langevoort, supra note 5 , a t 400 - 0 1 ( describing restriction o f insider trading as
"emotional in its genesis" and as political attempt to satisfy "those who feel u nfairly disad
vantaged by the absence of power, size, or status").
2 36
H ence the villain in the movie WALL STREET, Gordon Gekko, can b e i dentified by his
philosophy: " Greed . . . is good." WALL STREET ( 20th Century Fox Film Corp. 1987 ) .
239
Judge Posner terms regulation fueled by a public feeling o r concern rather than an
economic or utilitarian analysis "public sentiment statutes." Richard A . Posner, Economics,
Politics and the Reading of S t a t u tes and the Cons t i t u t io n , 49 U. CHI. L REv. 263, 287
( 19 8 2 ) . Insider trading legislation may be a prime example of a public sentiment statute.
234
[Vol. 26 : 1 7 9
sider trading regulation and strict enforcement efforts by the
SEC240 because, after insiders, they are the next best able to obtain
and use market-sensitive information .241 Stockholders support in
sider trading regulation b ecause of their perception that insider
trading is harmful and because it is easier to have that j udgment
made by Congress than to analyze the question firsthand.
In contrast, those who oppose such regulation are n ot in a posi
tion to mount a public campaign for deregulation . C orporate insid
ers would betray their beneficiaries by endorsing a regulatory sys
tem that allows insiders t o exploit their positions for private gains.
Individual tippees generally receive inside information on an un
predictable and fortuitous basis. Absent systematic access to such
information , they are not likely to agitate for change. Temporary
insiders, such as lawyers and investment bankers, risk the same
type of disapprobation as that faced by traditional insiders if they
support deregulation . In addition, promoting the freedom of pro
fessionals to trade on information provided by their clients would
be l ikely to result in contractual modification that, at a minimum,
would require the outsiders to disgorge such trading profits to their
corporate clients .
This combination of public disapproval and i ndustry support
virtually guarantees the continued regulation of insider trading. In
dustry professionals constitute active and knowledgeable partici
pants in SEC and congressional decisionmaking on regulation and
enforcement of the securities markets. They often serve as advisors
to Congress and are, directly and indirectly, the source of congres
si onal perceptions as to the effect of insider trading regulation on
the securities markets and the economy.242 Congress is particularly
" " Some scholars, such as Professor Macey, argue that market p r o fess i o n a l s try to p e r
s u a d e the p ub l i c t h a t i n s i d e r t r a d i n g i s w r o n g because t h e successful i n fl u e n c e o f p u b l i c
o p i n i o n w i l l result i n increased r e g u l a t i o n a n d e n forcement of the p r o h i bition a g a i n st i n s i d
e r s , and t h o s e who are next b e s t able to u s e the i n formation will p rofit thereby. Jonath a n R .
Macey, Ethics, Econom ics, and Insider Trading. Ayn R a n d Meets the Theory o f t h e Firm,
11 HARV. J.L & Pus. PoL'Y 785, 803 ( 1 988).
" " See David D . Haddock & ,Jona than R. Macey, Regula tion on Dema nd: A P r i va t e In
t erest Model, with an Application to Insi der Trading Regu lation, 30 J L . & EcoN. 3 1 1 , 3 2 9 :30 ( 1 987) (arguing t h a t i nsider trad i n g regulation results i n greater d istr i b u t i o n of t r a d i n g
p rofi ts to i n d ustry professionals than to gene ral p u b l i c and t h a t this d is t r i bution r e s u l t s i n
pol itical efforts b y such professionals i n s u p p ort of greater regulation a n d e n fo rce m e n t ) .
"" See id. a t 3 1 9 - 2 4 (desc r i b i ng i n s i d e r trading regulation as resp o n s i v e t o the p o l i tical
consti t u ency that bene fits from such regulation, p r i m a r i l y market profess ion a l s ) .
199 1 ]
INSIDER TRADING
235
unlikely to disregard the recommendations of these professionals
in l ight of the public aversion to insider trading. A member of Con
gress would be loathe to risk disapprobation by taking on the de
regulation of insider trading, a reform that enjoys no substantial
public support.
IV.
THE RESULT OF THE ANALYSIS: A NEW PROPOSAL FOR
REGULATION O F INSIDER TRADING
The foregoing analysis demonstrates that continued regulation
of insider trading is likely because of political realities, regardless
of whether economists can demonstrate an empirical effect of in
sider trading on the market or advocates of market fairness can tie
insider trading to the availability of capital. This Article also has
demonstrated that the existing system of regulation is unsound
and that the best justification for prohibiting insider trading is
that insiders owe a fiduciary duty to the market not to abuse their
position by taking personal advantage of nonpublic corporate
information.
Today, it appears that resistance to a statutory definition of in
sider trading may be weakening; C ongress, commentators, and
even the SEC have been attempting to draft a definition . 243 These
principles may serve to inform decisions about the appropriate
statutory scheme. In developing a statutory scheme, we should be
aware that calling it a statutory definition of insider trading
prejudges the issue. In the absence of a strict parity-of-information
standard , the statute will be deciding, in effect, who should be free
to use material nonpublic information.
143 A number of legislative proposals defining insider trading have been d eveloped in the
past several years. These include a proposal d rafted by a group of private securities lawyers
(the "Ad H oc Committee") at the request of Senators R iegle and D'Amato, which was intro
duced as S. 1 380, lOOth Cong., 1 st Sess. ( 1 987) , reprin ted in Symposium, supra note 1 27 , at
531 -34 app.; a proposal developed by the New York Stock Exchange Legal Advisory C o m
mittee, Report of the New York Stock Exchange Legal Advisory Committee, Proposed Stat
utory Definition of Insider Trad ing ( 1 987), reprin t e d in Symposium, supra note 1 27 , ot 54344 a p p . ; and a proposal prepared by the SEC, reprinted in Symposium, s u p ra note 127. at
.) 35-42 app., which was subsequently modified to conform to the approach of the Ad Hoc
Committee's proposal. See SEC Modified Proposal, supra note 1 27 . Congress req uested that
members of the Ad Hoc Comm ittee meet with the SEC and prepare Reconcili ation Draft of
S. 1 380, repri n t ed in Symposium, supra note 1 27 , at .5 52-58 app. The draft never game;-ed
the full support of e ither the Committee or the SEC. For a detailed analysis of these propos
als, see P h il l ips '� Lavoie, supra note 5 , at 457-62.
236
[Vol. 2 6 : 1 7 9
The proposal suggested by this Article departs most radically
from existing proposals and literature by rejecting the focus on the
method by which a trader acquires nonpublic information. By pre
mising liability on an insider's duty to the marketplace, this propo
sal is able to avoid the quagmire of analyzing the method of acqui
sition, as well as the private contractual and other relationships
between the trader, the issuer, and the source of the information.
The current proposals for a statutory definition of insider trading
analyze whether the information has been acquired wrongfully.244
Through the requirement of wrongfulness, they attempt to incor
porate current law on breach of duty, breach of relationship of
trust and confidence, and so forth. 245 This approach is misguided.
Additionally, regulation of insider trading would be improved by
reclassifying such trading as a regulatory violation rather than a
crime. A complete examination of the effect of decriminalizing in
sider trading is beyond the scope of this Article, but it should be
noted that Congress would be justified in prohibiting a broader
range of trading, based on concerns about market fairness, if such
trading were not penalized by criminal sanctions.
Given the lack of consensus on whether insider trad ing should be
regulated and, if so, the justification for such regulation, it is sur
prising that insider trading has generated so much recent media
and enforcement attention. Although public and j udicial opinion
appear to condemn insider trading as the moral equivalent of
theft,246 it is not clear that this perception is accurate. Treating
"" See, e.g , S . 1 380, l OOth Cong. , 1 st Sess. § 2 ( b) ( l ) ( 1 98 7 ) (prohibiting use of nonpublic
i n formation i f trader " kn ows or i s reckless i n not knowing that such i nfor mation h as been
obtained wrongfully, or i f the p urchase or sale of such security would constit ute a wrongful
use of such i n formation " ) , repri n t e d i n Symposium , s upra note 1 27 , at 532 a p p . ; SEC Mod i
fied Proposal, s upra note 1 27 , § 2 ( b) ( l ) ( prohibiting use of nonpublic i n form 3.tion if trader
" knows or recklessly d isregards that such i n formation has been obtain e d wrongfully, or that
such purchase or sale would constitute a wrongful use of such information " ) .
140
See, e.g. , S. 1 380, lOOth Cong. , 1st Sess. § 2 (b ) ( l ) ( 1 987) ( reconci l i ation d r a ft ) , re-
pri n t ed in Symposium, supra note 1 27 , at 554 app.
For the purposes of this subsection, such trading while in possessi o n o f mate
rial, nonpublic i n formation is wrongful only if such information has been ob
tained by, or its use would constitute, d i rectly or indirectly, ( A ) theft , bri bery,
m isrepresentat ion, espionage (through electroni c or other means) or ( B ) con
\'ersion , m isappropriation , a breach of any t!duci ary duty, any p e rsonal
or
other relationship of trust and confidence, or any contractual or employ m e n t
relationship.
"" For examp l e , the Second Circuit described i nsider trading in Un i t e d S t G t e.'
L'.
Carp r> n -
1991]
INSIDER TRADING
237
insider trading as stealing is consistent with a property-rights ap
proach, but if the regulation is refocused on the harm to the mar
ketplace and the insider's duty to disclose to that marketplace , the
insider trading violation might more accurately be likened to lying.
A moral evaluation of lying, however, is more difficult. Societal
views of lying are equivocal: society treats some lies as worse than
others.247 lVIoreover, in view of the fact that insider trading results
only in omissions and not in affirmative misrepresentations, it is
not necessarily the moral equivalent of lying. There is a distinction
in moral terms between affirmative misrepresentations and omis
sions. To a certain extent, it is anomalous that the jurisprudence of
common -law fraud has accepted the concept that liability may be
predicated upon material omissions,248 a concept that has worked
its way into statutory theory as well. Traditional philosophical the
ory supports the view that it is far worse , from a moral perspective,
to mislead than simply to omit relevant facts of which no inquiry
has been made.249 Indeed, this principle is reflected in current ju
risprudence. 250 These philosophical roots support the argument
that insider trading is not the moral equivalent of lying.2 5 1
If insider trading cannot readily be equated with either stealing
or lying, it is difficult to condemn such trading as i mmoral or in
herently wrong. Therefore, from a moral perspective, classifying
such trading as criminaP52 and penalizing it with stiff prison
ter as " conduct constituting secreting, stealing, [or] purloin i n g . " 7 9 1 F . 2d 1 02 4 , 10:3 1 (2d
C i r. 1 986).
247
See, e.g. , SISSELA BoK. LYING: M o RAL C H OICE I N P UBLIC AND PRIVATE LIFE ( 1978) (ex
amining reprehensi b i l i ty of lying i n variety of settings ) .
" " ' Such liability requires, of course, t h e presence of a d uty. S e e supra P a r t LA ( d iscuss
ing requirement of d uty to d isclose in classical theory of insider tra d i n g ) .
"" See, e.g . , MARCUS CICERO. D E OFFICIIS B K . III 321 ( W . M i l l e r t r a n s . 1 968) (
"
' I t is o n e
thing to conceal,' . . . , ' not to reveal i s q uite a d iffer e n t thing. ' " ) . F o r a d e t a i l e d analysis o f
the relative ethical or m o ral culpabili ty of nondisclosure and m isrepresentation as viewed by
a number of classic- philosophical scholars, see Lawso n , supra note 1 2 5 , at n 7 - 4:3.
""'' See supra note 189 ( discussing n o n disclosure in Texas G u lf Sulphur case).
2"
I f i nsider trading constitu tes lying, decisions by insiders based o n n onpublic informa
tion to refrain from trading should also be actionable as fraudulent omissions. Insider non
trading, al though perhaps d i fficult to prosecute, presents the same moral issue as i nsider
trad ing. See Easterbrook, supra note 37, at 336-37 ( arguing that i n s i d e r nontrad ing may
atfect stock pri ces just as insider tradi n g does). Nonetheless, a decision by an insider or
tippee to refrai n from selling stock, for example, based on superior i n formation about an
upcoming corporate development, is apparently legal.
2 52
S e e , e.g. , WAYNE R. L A F A V E
& AusTIN W . Sc oTT, JR. H A NDBOOK O N C R I M I N A L L..>.w
§ 1 . 2 , at 1 1 (2d ed. 1 986) (explaining that major purpose of criminal laws
i s enforcement o f
238
[Vol. 2 6 : 1 79
sentences should be reconsidered. 253
THE FIRST REQUIREMENT: INSIDER STATUS
A.
Although the presence of a fiduciary duty may be a factor in
determining insider status , it should not determine when informa
tion can be used as a basis for trading.254 Rather, a legislative solu
tion should focus on defining the insider class. 255 Once the class is
defined, thereby identifying the c lass of persons for whom the per
sonal use of nonpublic information breaches their duty to the mar
ketplace, insider class status alone should be the basis of restrict
ing trading.256 Status as an insider should be determined by
society's idea of morality); cf. Ronald J . Rychlak, Society 's Mora l Right t o Punish: A Fur
t h er Explora tion of the Denunciation Theory of Punishm e n t , 65 TuL. L. REv. 299, 329
( 1 990) ( " [ N ] ot a l l crimes are i m moral, and not all immoral acts are cri m inal. " ) .
203
Although the EEC Insider Dealing D i r ective prohibits insider trading, it does not re
quire member states to make such trading criminal. See genera lly Raffael l o Fornasier, The
Direc tive on Insider Dea ling, 13 FoRDHAM lNT'L L.J 1 49 ( 1 990) (discussing legal basis and
effects of EEC I nsider Dealing D i rective ) ; Hopt, s upra note 18, at 56-57 ( arguing that by
leaving sanctions to member states, d irective i s a compromise) .
n • The d i fficulty o f applying the duty approach i s aptly illustrated by both Reed and
Chestman. I n Reed, the court searched through principles of trust law, fiduciary law, and
even the law of restitution i n an attempt to locate some clear standard as to when an action
able breach of duty results from betrayal of a fam ily confidence. See United States v. Reed,
6 0 1 F. Supp. 685, 703 - 1 8 ( S . D . N . Y . ) , rev 'd in part o n other grou nds, 7 7 3 F . 2d 477 ( 2 d Cir.
1985). Notably, although the court did not go so far, sources relied on by the court suggest
that a close fam i ly relationship is, by itself, sufficient to confer a relationship of trust and
confidence. See 4 GEORGE E. PALMER, THE LAw OF RESTITUTION § 1 9 . 3 , a t 1 1 3 ( 1978) (ex
plaining that "there is a strong inclination to find a confidential relationship from the fact
of a close family connection ") (quoted in Reed, 601 F. Supp. at 7 10 ) .
Additionally, predicating insider trading liability on the breach of a fiduciary duty would,
presumably, allow a corporation to authorize i nsiders to trade i n its securities by submitting
the issue to the board or the shareholders for approval. Wolfson, supra note 197, at 1 1 3.
205
As the Supreme Court explained in Dirks, the point of insider trading regulation is " to
focus on policing insiders and what they do . . . rather than on policing i n formation per se
and its possession . " D irks v. SEC, 463 U.S. 646, 663 ( 1 983) ( quoting In re I nvestors Mgmt.
Co., 44 S.E.C. 63:3, 648 ( 19 7 1 ) (Smith, C., concurring in result) ) .
206
The idea of a status-based restriction has its seeds i n the insider trading regulations of
Great Britain, which, inter alia, restrict trading by persons " connected with" a company.
" Connected with" means holdi ng a position such as d irector, officer , or e mp l oye e , or having
a professional relationship, such as a lawyer-client relationship, that affords access to non
public information. See Company Securities ( Insider Dealing) Act, 1 985, ch. 8 ( Eng. ) . The
provisions of the B ri tish statute are described i n Mark A. S p i tz , Note, Recent Developments
in Insider Trading Laws a n d Problems of Enforcement in Great Brita i n , 1 2 B . C . INT'L &
Cmw L REv. 265, 2 7 5 - 8 3 ( 1 989 ) . The EEC I nsider Dealing Directive also focuses on status
as a hasis for l iabil ity, although it defines " insider" broadly, including within that category
v i rtually ail persons who have a relationsh i p with the 1ssuer and obtain i nformation by vir-
.l
1
I
l
I
I
�
.j
l
;
1
1 99 1 ]
INSIDER TRADING
239
considering the objectives of market regulation rather than princi
ples of agency law. Viewing insider trading regulation in terms of
market regulation does not place the emphasis on harm to the cor
poration or its stockholders, issues more appropriately left to state
fiduciary law.257 Moreover it makes no sense to focus on the wrong
ful nature of acquisition; there is no tie between injury to the in
formational source and the obj ectives ·of securities regulation .
Rather, the definition should be designed to address the harm that
insider trading causes to the marketplace.258
One important element of the regulation is its relationship to the
statutory disclosure system. To the extent that an insider controls
disclosure of corporate information, that insider has not only supe
rior access to information but also the opportunity to manipulate
the timing and quality of disclosure. Limiting the incentives for
such manipulation serves the objectives of prompt and complete
disclosure as well as the insider trading regulation objectives of
market fairness.
Accordingly, the class of insiders should include those who are in
a position to control corporate disclosure. In addition , much of the
perceived unfairness of insider trading is based on the idea that
management is able to beat the market; even in circumstances in
which information is disclosed promptly, management is able to
trade immediately prior to or concurrently with the disclosure, ob
taining as a windfall the value of the market reaction to that dis
closure .259 Thus, corporate insiders have an unerodable advantage
in terms of access. The quality of this advantage depends, in part,
on the level of the employee. High-level employees have a system
atic advantage in terms of access because they are in a position to
tue o f that relationshi p , as well as tippees. See H op t, supra note 1 8, at 62 -65 (describing
groups included by directive i n category o f insider ) ; see a lso Langevoort, supra note 5, at
4 1 1 (suggesting system o f insider trading regulation that focuses on whether trader has " po
sition of access " ) .
" " ' See Barbara A . A s h , State R eg u lation o f Insider Trading - A Tim e ly Resurgence?, 4 9
O H I O ST. L.J. 393, 398 ( 1 988).
'"" See supra n ote 181 (discussing possible harms of i nsider trading to marketplace ) ; see
a lso H .R REP. No. 1 383, 73d Cong., 2d Sess. 1 1 ( 1 934) ( discussing importance of disclosure
in functioning of markets and correlating market price with value ) . " [T ] h e hiding and se
creting o f i mportant i n formation obstructs the operation of the markets as i ndices of real
value." !d.
'"" See SEC v . Texas Gulf Sulphur Co., 401 F.2d 833, 853-54 nn. l ? - 1 9 (2d Cir. 1 968) (en
bane ) ( d iscussing timing of ord ers p laced by insiders ) , cert. den ied, 394 U . S . 976 ( 1 969 ) .
.l
240
[Vol. 2 6 : 1 79
learn about all significant corporate events as well as plans for dis
closure of those events.
It is important not to draw the class of insiders too broadly. The
superior access of corporate employees must be balanced against
the difficulty an employee may have in determining, before the
fact, whether he is in p ossession of ma t eria l nonpublic i nforma
tion. Virtually any employee is likely to have an advantage over
the general public in evaluating his own company, but this superi
ority alone should not preclude the employee from trading. Assum
ing employee stock owr.ership is desirable,260 deeming this advan
tage unfair is overbroad. Moreover, for lower-level employees,
unlike officers and directors, the trading opportunities created by
exposure to significant corporate events are likely to be random
and occasional i n nature and are less likely to interfere with corpo
rate decisionmaking. Occasional access to nonpublic information
can be addressed through the category of secondary insiders de
scribed below.
For purposes of section 1 6 of the Exchange Act, insiders are de
fined as officers, directors, and ten percent stockholders. 261 This
proposal takes that definition as the starting point for purposes of
insider trading and includes those persons as "primary insiders"262
zao
The practice of permitting corporate insiders to trade the stock of their company is
generally defended on the grounds that this practice aligns management i nterests more
closely with those of the stockholders and minimizes the agency costs associated w i th the
separation of ownership from control in the large publicly held corporation. See generally
Eugene F. Fama, Agency Problems a n d the Theory of the Firm, 88 J. PoL. EcoN. 288 ( 1980 ) ;
Oliver Hart, A n Economis t 's Perspective on t h e Theory o f the Firm, 8 9 CoLUM. L . REv. 1 757
( 1 989); M ichael C . Jensen & William H. Meckling, Theory of the Firm: Manageri a l Beh a v
i o r , Agency Costs a n d Ownership Struct ure, 3 J. FIN. EcoN. 305 ( 1976 ) . A bsent such a view,
corporate i nsiders could simply be precluded from trading i n their company's stock, a prac
tice that would substantially reduce opportunities for insider trading. See Levmore, supra
note 1 8 1 , at 1 29-32, 1 57-58 ( acknowledging systematic advantage that corporate insiders
have when trading i n their company's stock and suggesting investment through blind trust
as alternative remedy) .
'"' See 1 5 U.S. C . § 78p ( 1 988) .
262
The terms "primary i nsiders" and "secondary insiders" were used by the European
Economic Commission during its prep aration of the Insider Dealing Directive, although they
do not appear in the d irective i tself. Hopt, supra note 1 8 , at 62. Usage of the terms herein
dif!"ers in that the EEC used the term " primary i nsiders" to refer to all classes of persons
who have a relationshi p with the issuer, including employees, lawyers, auditors, suppliers,
etc . , and used the term " secondary insiders" to refer to tippees. !d. at 62-65. Because this
proposal does not i mpose liability on the trading activities of tippees, it i s possible to be
more precise i n the classification of insiders.
199 1 ]
INSIDER TRADING
241
because they generally have (1) the ability to affect the content
and timing of corporate disclosure; ( 2 ) regular access to informa
tion on significant corporate events; and (3) the ability to affect the
decisionmaking process about such events. This proposal then
adds to the category of primary insiders other persons employed
by the corporation who by virtue of their employment h ave regular
acce ss to decisions on corporate p ol icy and disclosure. The purpose
of this addition is to make the section 16 class of insiders more
flexible by treating insider status as a function of responsibil ity
and access as well as position.263
To this class of primary insiders, the proposal adds a second cat
egory denominated " secondary insiders." Secondary insiders are
those who by virtue of an employment or other contractual rela
tionship receive nonpublic information relating to the issuer or its
securities for the purpose of advising or rendering services to the
corporation or its management.264 S econdary insiders include b oth
outsiders, such as lawyers and investment bankers , who are hired
to advise or represent the corporation,265 and employees who have
26 3
The modification is akin to that introduced by the SEC in its recent amendments to
the regulations under section 1 6 , in which the SEC determined that the category of officer
should be defined in terms of " policy-making function" rather than title. See 17 C . F . R . §
240. 1 6 a - 1 ( f) ( 1991 ) .
264
The receipt o f nonpublic information b y a secondary insider need not b e a regular
occurrence; insider status under this provision may be based on an isolated exchange of
information, such as that which occurs when a lawyer is hired to represent a corporation
with respect to a single transaction.
26 0
The proposal would not classify as insiders those traders sometimes described as
" market insiders" ( i. e . , those who by virtue of their position or the types of services they
perform have regular industry access to nonpublic information ) . See Maria T. Galena, Note,
Drawing the Line on Insiders and Outsiders for Rule l Ob-5: C hiarella v. U ni ted S tates, 4
HARV. J . L. & P u s. PoL'Y 203, 233-41 ( 1 981 ) (arguing that those with regular access to non
public information should be treated as insiders based on claim that those traders breach
their duty because they have obtained information " by virtue of a structura: position within
the market").
The use by market insiders of nonpublic information can take two forms: insiders may
trade on the information directly or allocate the information, effecting wealth d istribution
through d isclosure to clients. The former problem can be addressed by prohibiting analysts
or their firms from trading on nonpublic information. Such a prohibition would not affect
the market d issemination function addressed by Congress and the Supreme Court. See
supra notes 220-22 1 .
The latter problem was the basis for the D istrict o f Columbia Ci rcuit's concern i n Dirks.
See Dirks v. SEC, 681 F.2d 824, 840 - 4 1 (D.C. Cir. 1982 ) , rev 'd, 463 U.S. 646 ( 1 983); see a lso
supra note 225 ( discussing analysts' selective disclosure as aggravating existing informa
tional disparities ) . It is clearly possible to conclude, as the court did in Dirks, 681 F . 2d a t
840-42, that securities professionals, by virtue of their position, owe fiduciary duties to the
242
[ Vol. 26: 1 7 9
access t o nonpublic corporate information o n an irregular o r infre
quent basis. 2 66
Trading by the above-described classes of insiders would be re
stricted as follows: it would be a violation of federal law for pri
mary insiders who possess material nonpublic information relative
to any security,267 obtained by virtue of their status as an insider,
to take advantage of that information by trading or tipping.268 It
would be a violation of federal law for secondary insiders who pos
sess material nonpublic information relative to any security, ob
tained by virtue of their relationship with the corporation, to take
advantage of that information by trading or tipping. Trading by
either class of insiders would be defined to include effecting trades,
for the insider's personal account or the account of others, on the
basis of nonpublic information. The provision would contain a
statutory presumption that an insider who possesses m aterial non
public information has based his trading on that information; this
p resumption could be rebutted through a showing, by the insider,
of a distinct legitimate basis for the trading in question.
B.
THE MEANING OF INSIDE I NFORMATION
Removing the emphasis on fiduciary duty demonstrates that a
major issue in defining insider trading is the question of what con
stitutes inside information. Although many issues are presented in
constructing a statutory definition of inside information , including
specifying when information is material and when it is n onpublic,
market at large not to engage i n selective d isclosure of nonpublic i n formation. B ecause se
curities professionals, i ncluding i n vestment advisors, and registered broker-dealers like
D ir ks , are heavily regulated by the federal securities laws, such duti es also can be i m p osed
directly by statute. As the court i n Dirks observed, however, the obligations o f securities
professionals i n this regard are distinct from the generally applicable antifraud provis ions.
I d. Accordingly, they should be addressed separately.
266
The European Insider Dealing Directive classifies certain government officials as insid
ers based on their access to market-sensitive i n formation. See Hopt, supra note 18, a t 6 2-65.
The British regulations also prohibit trading by public servants. Spitz, supra note 2 56 , at
278; see a lso G alena, supra note 265, at 204 n.5 ( d iscussing insider status of government
employees ) . Consideration of the appropriate treatment of government officials i s beyond
the scope of this Article.
267 Because the proposal does not premise liabi lity on the breach of a fi duciary duty, i n
siders violate t h e provision b y trading i n a n y security o f t h e issuer, whether i t i s d e b t or
equity. See supra note 5 2 (debating whether trad ing i n debt securities violates current i n
sider trad ing law) .
268
For an explanation of what constitutes impermissible tippi ng, see infra Part I V . C .
1991]
INSIDER TRADING
243
one that seems most difficult is deciding when information is "in
side" with respect to a class of insiders. Is an insider barred from
trading on the basis of n onpublic information that relates only to
the corporation to with the insider is connected269 or from using
any information he receives by virtue of insider status, even if that
information relates to the stock of another issuer?
Both the British statute and the EEC directive seek to prohibit
the use of any information acquired by virtue of the insider's sta
tus or position,270 but it is not clear that this broad scope is appro
priate. Again , it is necessary to look at the rationale behind the
prohibition and the availability of alternative methods of
regulation.
The economic rationales for prohibiting insider trading are
weakest when the trader is an outsider with respect to the issuer of
the securities traded. A corporate employee who learns, in the
course of his employment, of information relevant to another is
suer is not in a position to control disclosure of that information,
to manipulate corporate events of the issuer, or to abuse a fiduci269
There are two separate issues in this analysis. F irst, does an outsider violate insider
tradi ng rules by using information obtained by virtue of business relations with the source?
And second , even if such trading would be permissible when effected by an outsider as prin
cipal ( i.e., a corporation or an i nd ividual) , is it i l legal i f the outsider is an employee (or
otherwise an agent) of a corporation and acquires the information by virtue of his employee
status?
27 0
U nder the British statute, this issue was resolved by defining i nside i nformation, to
i nclude i nformation relating to any actual or contemplated transaction between the insider's
company and another company. Insiders are prohi b i te d from trading in the securities of the
other company while i n possession of such i nformation. Thus, inside i n formation for pur
poses of the B r itish law includes i nformation both about the issuer and about the issuer's
transactions with other companies. Company Securities ( Insider Dealing) Act, 1 985, ch. 8
( Eng. ) ; see S pitz, supra note 256, at 277.
The coverage of the EEC I nsider Dealing Directive is s i mi lar. I t defines inside information
as simp ly
information which has not been made public of a precise nature relating to one
or several issuers of transferabl e securities or to one or several transferable
securities, which, i f i t were made public, would be likely to have a significant
effect on the price of the transferable security or securities i n question.
Council D irective 89/592 Coordinating Regulations on I nsider Deaiing, art. 1 , 1 989 O.J. (L
334) 30, 3 1 , quoted in Hopt, supra note 18, a t 57. Thus, i nside i nformation can relate to the
securities or the issuer. U nder the directive's provisions, inside information cannot be uti
l ized by insiders, who, for the p urposes of the D irective, i nclude, inter alia, anyone who
obtains inside information by virtue of his profession, duties, or business relationship with
the issuer. Thus, insiders m ight include suppliers, clients, or participants in a planned
merger. Council Directive 89/592 Coordinating Regulations on I nsider Dealing, art. 2 , 1 989
O J. ( L 334) 30, :3 1 ; Hopt, supra note 1 8 , at 64.
.•
244
[ Vol. 26: 1 7 9
ary pos1t10n with respect to the issuer's stockholders. Nor is the
employee appropriating property that belongs to the issuer as long
as the information was legally obtained by the employee or the
corporate employer. Moreover, information relating to third par
ties often falls within a grey area with respect to confidentiality.
Although both the bidder and the target would hope to maintain
confidentiality of information relative to a prospective tender offer,
information relating to the business plans, orders for supplies, etc.,
may not be explicitly proprietary or secret.271
The British and EEC positions272 take the broadest approach,
defining as inside information all material nonpublic information
with respect to either the employer or the second corporation.273
The fact that information is nonpublic, however, does not make it
either confidential or proprietary. As a practical matter, some in
vestor is always going to be the first to discover new information
about a company, and it seems unreasonable to disqualify the in
vestor from using the information simply because he acquired it by
virtue of employment.
An alternative approach would include as inside information all
material nonpublic information that either the target or the em
ployer wants to keep confidentiaU74 The difficulty with this ap
proach is that the ability of the investor to use the inform ation
may depend on decisions of a corporation that does n ot employ
him , to which he may owe no duties, and that, arguably, s hould not
b e able to bind him. Moreover , the target clearly could not restrain
third-party individuals or entities directly, absent a contractual
agreement; it should not be able to restrain traders simply by vir
tue of their status as corporate employees.
"11
Both Rothberg v. Rosenbloom, 7 7 1 F . 2 d 8 1 8 , 820 ( 3d Cir. 1985 ) , see supra note 1 75 ,
and SEC v. L u n d , 570 F . S u p p . 1 3 9 7 , 1 4 0 1 ( C . D . C a l . 1983 ) , see supra n o t e 1 68, i n volved
such nonproprietary i n formation. The ambiguity in both cases is i llustrated by the courts'
assumptions that, although the i n d i vidual defendants ' trading was illegal, tradi n g by the
defe n d ants' business employer would have been lega l .
" ' " S e e supra n o t e 2 7 0 ( discussing B r i t i s h a n d EEC provisions).
m Thus, under these definitions, both the tender offeror and the supplier i n the examples
in Pare II.C. of this Article would be precluded from trading. The B ritish statute p rovides
that a p rospective bidder may buy the stock of the target company in order to effect the
takeover, but not otherwise. Company Securities (Insider Dealing) Act, 1 985, ch. 8, § 1 (5 )
( Eng. ) . The provision is ambiguous as t o whether preannouncement trading b y t h e bidder is
legal.
" � ·• This p rovision could be strengthened by requiring that the corporation take affirma
t i v e s t e p s to m a i n tain the confidential ity of the i n formation.
"i
I1
ll
1
i
�
�
l
1 99 1 ]
INSIDER TRADING
245
The third option is to preclude the employee from trading on
i nformation that is confidential and proprietary in the hands of his
e mployer. Thus , the test of whether information is " inside " under
th is approach is not whether it relates to the securities of the com
p any with which the insider is connected, but rather whether the
corporation has some sort of interest, proprietary or property, in
th e information. This test may be analogized to the corporate op
portunity doctrine, in which a corporate employee may not appro
priate a business opportunity that is of value to the corporation for
his personal benefit.275 Whenever a corporate employee uses infor
mation that has a value to his employer for personal use, there is a
dive rsion of value from the corporation to the employee.276
This approach to inside information views a corporation's infor
mation as a form of intangible property. The corporation may,
through confidentiality regulations, employment contracts, or oth
erwise,277 restrict its employees' abilities to use that information.278
m See, e.g. , Guth v. Loft, Inc. , 5 A.2d 503, 5 1 1 (Del. 1939) (discussing corporate opportu
nity doctri n e ) .
, 7 6 One m i g h t observe t h a t firms a r e taking a broader v i e w o f p roprietary i nformation in
areas other than securities trading. For example, contractual arrangements that restrict an
emp loyee's ability to compete with the firm after termina tion of employment are prem ised
on the notion t h a t the firm has a proprietary interest i n the employee's human capital, the
knowledge and skill acquired by the employee during his tenure at the firm. See K itch,
supra note 198, a t 684-86 (describing fi r m 's interest i n "human capital " ) .
27 7 M any employer-employee cases present difficult problems o f proof under this ap
proach because of the absence of any explicit effort by the employer to m a intain the infor
mation as confidential. I t has been suggested that, even i n the absence of a written agree
ment, there may be an implicit contractual agreement by the employee to maintain
corporate i n formation as confidential. See Wolfson, supra note 197, at 1 07 -08. This is par
ticularly true with respect to certain m arket-sensitive information such as the existence of
merger negoti ations or a pending change in dividend policy, which is l ikely to be viewed by
the corporation as confidential and treated as such even in the absence of contractual
restrictions.
278
This a pproach conversely would permit corporations to opt out of insider trading regu
lation, at least i n part, by refusing to treat corporate i n formation as proprietary or confiden
tial. The treatment of information as intangible property would make the employee's use of
the information a breach of his duty to the corporation based on the combination of the
contractual provisions and the obligations of confidentiality thereunder. This definition is a
way of clarifying the breach of duty articulated by the court in R o t h berg u. Rosenbloom. As
the court stated, " [a ] n insider on either side of a proposed transaction violates the insider
trading rule when he uses insider i n formation in violation of the fiduciary duty owed to the
corporation to which h e owes a d uty of confidentiality." Rothberg v. Rosenbloom, 7 7 1 F.2d
8 1 8, 822 ( 3d Cir. 1985). The shortcoming i n the Rothberg court's analysis is i ts fai l u re to
analyze the source of the defendant's d uty of confidentiality. Instead, the court seems to
premise a general d u ty of con fidentiality on the general duties i n h e r e n t i n the e m p l oyment
246
[ Vol. 26: 1 7 9
As a property rights theory, this approach i s logical. Moreover, this
notion of insider trading bears the greatest relation to the agency
principles from which insider trading liability has evolved.
Finally, the least restrictive view of inside information is to cate
gorize information as " inside" only if it relates to the issuer or the
securities of the issuer to which the insider is connected.27 9 The
justifications for this approach include the fact that only in this
situation are concerns about manipulation, moral hazard, and de
lay of disclosure j ustified. Moreover, this view of inside informa
tion speaks to the rationale behind the level-playing-field theory of
r egulation. Arguably, the situation in which insider trading is most
unfair to the marketplace is the case in which a corporate insider,
by virtue of his position, obtains material information that enables
the insider to value the corporation's stock more accurately than
outside investors. 2 80
C.
REGULATION OF TIPPING
The proposed provision would deal more harshly than current
law with insiders who tip confidential information to others. Tip
ping by insiders would be defined as selective disclosure of infor
mation by an insider under circumstances in which trading by the
insider would be illegal. The proposal presumes that such tipping
benefits the insider, directly or indirectly.281 Accordingly, the pro
vision would impose liability on tippers regardless of whether a pe-
relationship.
One difficulty with this approa;:;h is that i t does not limit the corporation's ability to re
strict the use of corporate information. While certai n corporate i n formation, such as trade
secrets or developments created by corporate action, may well b e p roprietary i n n a tu re , i t is
not obvious that all corporate information is proprietary simply because i t comes i n to the
possession of the corporation or because a corporation has property rights in all the i n for
mation it possesses. For a detailed d iscussion of the Lockean theory of i n formation as prop
erty and the corporation's rights to such property, see Lawson, supra note 1 25, a t 763-69.
2 ' " This definition of inside i n formation would make cross -trading legal. See supra note
1 7 1 ( discussing cross- tra d ing) . The same approach is taken by the 1988 J apanese statute.
S h oken torikikihb ( S E L ) , Law No. 25 of 1 948, a m e n ded by Law to Amend a Part of the
SEL, Law No. 7 5 of 1 988; see A kashi, Note, supra note 17, at 1 :306 - 1 0 .
"' "0 See Akaski, Note, supra note 17, a t 1 3 1 2 (describing unfairness of allowing persons
who have special relationship with issuer whereby they are able to generate, or at. least o b
tai n , ready access to i n formation about issuer to use i n formation in trad ing w it h p u blic
investors ) .
"81
The case of an insider who tips by m istake could l:Je addressed by applying Rule l 0 b 5's requirement of scienter to i n s i d e r trading. See Ernst & Ernst v . Hochfelder, 4 2 .5 U . S .
1 8.5 , 1 99 ( 1 976 ) . Thus, t o be liable, t h e tipp ei must have acted with at least recklessness.
1991]
INSIDER TRADING
247
c uniary motive could be established for tipping.2 82 Insiders would
be liable for profits earned by tippee trading based on a two-part
test. Insiders who disclose confidential corporate information to
third parties who subsequently trade on that information would be
liable for the profits earned through such trading, if the insiders
acted negligently or wrongfully in disclosing the information283 and
if the tippee's trading was reasonably foreseeable.
The purpose of broadening liability for tippers is to deter the
creation by corporate insiders of informational inequalities through
selective disclosure. If insider trading is harmful to the markets
because those on the inside enjoy unfairly superior access to infor
mation compared to average investors , the types of insider-analyst
relationships that create superior access should also be minimized.
This formulation responds to two concerns: the SEC's concern that
corporations improperly use investment analysts to make selective
disclosure,284 and commentators' concern that investment analysts
contribute to a market in which insiders in a broad sense, such as
professional investors , have an unerodable and unfair informa
tional advantage.285
While dealing more harshly with tippers , the proposed regula
tion would abolish the regulation of insider trading by tippees. The
only trading on the basis of nonpublic information that would be
restricted is that engaged in by statutory insiders. 286 Rather, tippee
2 82
Thus, the provision would abolish the standard set by Dirks that an insider breaches
his fiduciary duty by tipping only if he receives a pecuniary benefit thereby. D i rks v. SEC,
463 U.S. 646, 662-63 ( 1 98 3 ) . L iability would not require proof of financial gain or proof that
the tipper intended to make a gift to the tippee.
283
In other words, an i nsider who d iscloses to a third party for transactional reasons (i.e.,
for a valid, non-disclosure-related corporate purpose) will not be liable i f the recipient of the
i n formation uses the information to trade. The tippee may, however, incur liability as a
secondary insider. For example, a corporate officer, who discloses a prospective tender offer
to the fi rm's attorneys so they can assist with preparation of the tender offer documents,
will not be l iable i f the attorneys trade on the i n form ation. The attorneys i n this case would
be treated as secondary insiders u nd e r the statute.
28' Fleischman, P resentation, supra note 220.
28 "
See supra notes 220-22 1 , 226 ( highlighting debate over whether analysts' informa
tional advantage i s unfa ir ) .
28 "
Thus, this proposal takes the opposite position from that o f the EEC d irective, which
im poses liability on tippees "who with full k nowledge of the facts possess [ ] i nside informa
tion, the direct or indirect source o f which could not be other than a [ pr i m a ry inside r ] . "
H opt, supra note 1 8 , at 7 1 ( quoti n g I nsider Dealing D irective, a r t . 4 ( E EC ) ) . U n der the
directive, t i p pees are prohibited from trading regardless of whether the primary insider has
disclosed the information lawfully. ld . Thus, the directive also rejects the "wrongfulness"
248
[Vol. 2 6 : 1 7 9
trading would be regulated indirectly by requiring tippers to be
responsible for the economic consequences of tippee trading.28 7
The rationale behind this provision is that the concept of deriva
tive liability, or derivative duty, is too difficult to apply, both for
the courts and for traders. It is impractical,288 and perhaps ineffi
cient,289 to require a tippee to analyze the source of his i nformation
to determine if, somewhere up the chain of information , there h as
been a misappropriation or a breach of fiduciary duty. Indeed, the
SEC appears to be making a practice of investigating and prose
cuting tippees on circumstantial evidence that trading was based
on inside information. 29 0 Some in the industry have described the
focus of the draft congressional definitions. S e e supra notes 243-245 and accompanying text.
2 8 7 A l though circumstances i n which the tipper i s judgment-proof and the tippee has gar
nered large trading profits appear to present an e n forcement problem, m ost such cases
would never arise under this proposal. The common ( an d most troubling) obj ective for the
tipper is pecuniary gain, and the disgorgement remedy addresses that gain. A dditionally, as
a p ractical matter, most of those within the class of statutory insiders, by virtue of their
position, will have attained substantial personal wealth such that, even if their motive for
tipping in a particular case is not pecuniary, the risk of a severe monetary p e n a lty w i l l deter
tipping.
28 8
Much of the information analyzed by traders and arbitrageurs consists o f market ru
mors and " soft" information. Moreover, empirical evidence suggests that m a n y significant
corporate disclosures are l eaked to the extent that the price of the stock has already begun
to reflect the information prior to any public disclosure of the information. See, e.g. , Gregg
A . Jarrell, Stock Trading Before the A nnouncement of Tender Offers: Insider Trading or
Market A nticipation, 5 J.L. EcoN. & 0RG. 225, 226-27 ( 1 989) ( finding price of target compa
nies i ncreased prior to first public announcement of a tender offer or merge r ) ; Paul H . Ma
latesta & Rex Thompson, Partially A n t icipated Events: A Model of Stock Price R e a c t ions
with a n Application t o Corporate A cquis i t ions, 14 J. FIN. EcoN. 237, 240 ( 1 985) (same ) ; see
a lso Levinson v. B asic, Inc., 786 F.2d 7 4 1 , 744-45 ( 6th Cir. 1 986) (describing how stock price
rose during merger negotiations despite public denials of corporate developments), vacated,
485 U.S. 224 ( 1 988). It may be virtually impossible for a market participant to engage i n the
necessary line-drawing i n such cases.
289
See supra note 15 ( d iscussing Court's concern in Dirks that such a requirement would
interfere with valuable function of market analysts) .
290
In a recent prosecution i n the Southern District of New York, for example, the SEC
sought preliminary i nj unctive relief as well as an order freezing the defendants' assets, based
solely on circumstantial evidence of insider trad i ng combined '>vith curiously timed trades.
SEC v. Foundation Hai, 736 F . Supp. 465, 4 7 1 -73 ( S.D.N.Y. 1990 ) . The d istrict court
granted the requested relief but was reversed in part by the Second C ircuit, which, a lthough
not condemning the SEC's fai lure even to identify the alleged tipper, found that the SEC
had not established a prima facie case entitling it to injunctive relief. SEC v. U ni fu n d SAL,
910 F.2d 1 028, 1037 (2d Cir. 1990 ) ; see a lso SEC v. H e ider, No. 90 Civ. 4636, 1 990 U.S. D ist.
LEXIS 1 6246, at * 1 1 - 1 2 (S.D.N.Y. Dec. 3, 1 990) ( d enying motion to dismiss complaint that
fai l ed to identify tipper). Defendant Heider explained his curiously timed trading to the
SEC by stating that he " ' overheard discussion in a restaurant to the effect that the price of
Conte! s tock would i ncrease because somethi ng was going to happen with the company. ' "
199 1 ]
INSIDER TRADING
249
SEC's stance as prosecuting on the basis of " curiously timed
trades. " Given the enforcement tools available to the SEC, it is
difficult for traders to defend themselves against such prosecu
tions , in which the SEC may require the trader to come up with
ind ependent justification291 for his curiously timed trades. 292 In ad
dition , the proposed judicial and statutory tests that require the
tippee to have actual or constructive knowledge that he has re
ceived inside information are difficult to apply to the realities of
tipping situations.293
Nor does tippee trading implicate the economic obj ectives of
early and complete disclosure that underlie regulation of insider
trading. A tippee is not in a p osition to control disclosure or to
manipulate corporate affairs to create trading opportunities. More
over, to the extent that tipping is harmful to the firm's interests,
the penalty for tipping should be borne by the tipper, who is re
sponsible ;or protecting those interests.294 Finally, by imposing
substantial civil liability on tippers, it is likely that the practice of
tipping, whether for profit or otherwise, will be adequately
Isabelle C lary, Court Freezes Assets in Suspected Cont e l Insider Trading Case , UPI, July
23, 1 990, availa b le in LEXIS, Nexis Library, UPI file.
""' For example, the d e fendant in United States v. Chestman, 947 F.2d 55 1 (2d Cir. 1 99 1 )
( e n bane ) , explained h i s trades i n Waldbaum stock t o the SEC b y stating that the trades
were the product of research " consistent with previous purchases of Waldbaum stock and
other retail food stocks and were supported by reports i n trade publications as well as the
unusually high trading volume of the stock on Nov. 25." Id. at 555.
29 2
The implication is that a trader has not simply done a good job of analysis. The SEC
has taken the position that, i f the trader demonstrates a pattern of anticipating market
i n formation, such prescience i n dicates the use of inside i n formation rather than effective
research techniques.
'"' In Ches t m a n , for example, K e ith Loeb testified on behalf of the government that he
told C hestman he had "some definite, some accurate i n formation" that would favorably af
fect the price of Waldbaum stock . 947 F.2d at 555. Loeb did not explain the source of his
i n formation or the basis for his belief that it was favorable. Id. A similar example is pro
vided by Dennis Levine's description of the information h e gave to Ivan Boesky in his tips:
I wasn't telling Ivan anything very specific-it was more a matter of suggesting
that, say, his investment i n XYZ Corp. seemed worth holding on to. I never
told him my oblique suggestions were based on nonpublic i nformation, but
over time he evidently learned their value.
Dennis B . Levine, The Inside S tory of A n Inside Trader, FoRTUNE, May 2 1 , 1 990, at 80.
Levine did not disclose to Boesky his sources of information, which included both his em
ployer, Drexel Burnham Lambert, Inc. , and investment bankers at other brokerage firms.
I d.
29' O f course, these values are not served to the extent that tipping may further the inter
ests o f the fi r m . See G arten, supra note 220, at 626-32.
250
[ Vol. 2 6 : 1 7 9
" nip [ped ] i n the bud."295
Although eliminating tippee liability would prevent prosecution
of many outsiders for insider trading, the provision does not abol
ish all remedies against those who acquire inside information
through improper or illegal means. Outsiders who acquire informa
tion through theft or the equivalent can be prosecuted under the
existing criminal laws. A source of information that is otherwise
injured or defrauded by an outsider trade also will be able to bring
a civil claim under traditional common-law and contractual reme
dies, such as a civil suit for theft of trade secrets or breach of a
confidentiality agreement. Addition ally, in the case of a lawyer , ac
countant, psychiatrist, or other professional who misappropriates
confidential client information, the breach of a professional rela
tionship of trust may be remedied through disciplinary proceed
ings, which might result in disbarment, license revocation, or pub
lic censure.
PENALTIE S
D.
The penalties authorized under this proposal would be commen
surate with those applicable to other violations of the securities
laws. In particular, courts could order disgorgement fro m the tip
per of up to three times any profit earned by insider trading.296 In
addition, tippers, under this proposal, would be liable for up to
three times the trading profits earned by their personal trading as
well as the trading of their tippees.
20'
As the Supreme Court explained:
The true insider or the broker-dealer is a t the fountai nhead of the con fidential
information . . . . I f the prophylactic purpose of the law is to restrict the use o f
all material i n s i d e information until it i s m a d e available to t h e investing p u b
l i c , then t h e most effective means of carrying o u t t h i s policy i s t o n i p i n the
bud the source of the information, the tipper, by discouraging him from " mak
ing the i nitial d isclosure which is the first step i n the chain o f dissem i n ation. "
B ateman Eichler, H i ll Richards, Inc. v. Berner, 4 7 2 U.S. 299, 3 1 6 ( 1985) ( quoting Nathanson
v. Weis, Voisin, Cannon, Inc., 325 F . Supp. 50, 5 7 - 58 ( S . D . N . Y . 1 97 1 ) ) .
206
The SEC m ight also be authorized to seek civil fines to enhance the fi nancial penalty
for insider trading consistent with i ts recently provided power under Section 2 1 . See 7 8
U.S.C.A. § 78u(d ) ( 3 ) ( West Supp. 1 99 1 ) (authorizing im position of civil penalties for viola
tions of securities laws ) .
.,
�
1
i
'
199 1 ]
INSIDER TRADING
251
CONCLUSION
Congress and the courts have spent the last forty years attempt
ing to articulate a rationale for regulating insider trading. Most of
the justifications for the current system of p rohibiting insider trad
ing as securities fraud under SEC Rule lOb-5 are seriously flawed.
Public perception of insider trading as a problem coupled with a
securities industry that would be seriously inj ured by deregulation
suggests that deregulation is unlikely. If regulation is to continue,
Congress should replace the current regime with a statute that is
clear and predictable. A statutory definition of insider trading
would provide the requisite notice to traders of the p otential ille
gality of their conduct and would not chill legitimate trading,
thereby promoting market efficiency.
This Article 's proposal attempts to replace the current system of
regulation with more of a bright-line test. In so doing, it proposes
three substantial changes: ( 1 ) moving the emphasis in insider trad
ing enforcement from criminal prosecution to civil disgorgement;
(2) changing the system to place the full burden of tippee trading
on the insiders who act as sources of the tips; and ( 3 ) replacing the
concept of regulation based on the trader's fiduciary and other du
ties with a system of regulation based on insider status. These
changes would produce a logical, coherent approach to insider
trading regulation.

An Analysis and Proposal for Insider Trading Regulation

Transcription

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